38 Pages Posted: 9 Mar 2011 Last revised: 27 Feb 2012
Date Written: November 2011
This paper investigates the extent to which market risk, residual risk, and tail risk explain the cross sectional dispersion in hedge fund returns. The paper introduces a comprehensive measure of systematic risk (SR) for individual hedge funds by breaking up total risk into systematic and fund specific or residual risk components. Contrary to the popular understanding that hedge funds are ‘market neutral’ we find that systematic risk is a highly significant factor explaining the dispersion of cross-sectional returns while at the same time measures of residual risk and tail risk seem to have little explanatory power. Funds in the highest SR quintile generate 6% more average annual returns compared to funds in the lowest SR quintile. After controlling for a large set of fund characteristics and risk factors, systematic risk remains positive and highly significant, whereas the relation between residual risk and future fund returns continues to be insignificant. Hence, systematic risk is a powerful determinant of the cross-sectional differences in hedge fund returns.
Keywords: hedge funds, systematic risk, time-varying risk, return predictability
JEL Classification: G10, G11, C13
Suggested Citation: Suggested Citation
Bali, Turan G. and Brown, Stephen J. and Caglayan, Mustafa Onur, Systematic Risk and the Cross-Section of Hedge Fund Returns (November 2011). Available at SSRN: https://ssrn.com/abstract=1781202 or http://dx.doi.org/10.2139/ssrn.1781202
By Bing Liang