Disagreement Exploitation and the Cross-Section of Hedge Funds Performance

Abstract

This study examines the role of market disagreement in explaining the cross-section of hedge fund performance. In a market where disagreement fluctuates, skilled arbitrageurs may employ different trading strategies to exploit the mispricing caused by disagreement and short-sale constraints. Skilled hedge funds with high sensitivity to disagreement can take advantage of mispricing in high-disagreement periods to improve their performance. We show that hedge funds with a high disagreement beta tend to have a disagreement exploitation skill and thus earn higher cross-sectional returns relative to other hedge funds that do not have this skill. Experienced hedge funds (proxied with size and age) and hedge funds that charge a high incentive fee are likely to have high disagreement betas.

Keywords: Hedge Fund Performance, Disagreement, Arbitrage