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Systematic Risk and the Cross-Section of Hedge Fund Returns

39 Pages Posted: 19 Dec 2011  

Turan G. Bali

Georgetown University - Robert Emmett McDonough School of Business

Stephen J. Brown

New York University - Stern School of Business

Mustafa Onur Caglayan

Ozyegin University

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Date Written: December 18, 2011

Abstract

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, residual risk, return predictability

JEL Classification: G10, G11, C13

Suggested Citation

Bali, Turan G. and Brown, Stephen J. and Caglayan, Mustafa Onur, Systematic Risk and the Cross-Section of Hedge Fund Returns (December 18, 2011). Available at SSRN: https://ssrn.com/abstract=1974242 or http://dx.doi.org/10.2139/ssrn.1974242

Turan G. Bali (Contact Author)

Georgetown University - Robert Emmett McDonough School of Business ( email )

3700 O Street, NW
Washington, DC 20057
United States
(202) 687-5388 (Phone)
(202) 687-4031 (Fax)

HOME PAGE: http://msbonline.georgetown.edu/faculty-research/msf-faculty/turan-bali

Stephen J. Brown

New York University - Stern School of Business ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0306 (Phone)
212-995-4233 (Fax)

Mustafa Onur Caglayan

Ozyegin University ( email )

Nisantepe Mahallesi Orman Sokak
No:34-36 Alemdag Cekmekoy
Istanbul, 34794
Turkey
+90-216-564-9518 (Phone)

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