Macroeconomic Risk and Hedge Fund Returns

Abstract

This paper estimates hedge fund and mutual fund exposure to newly proposed measures of macroeconomic risk that are interpreted as measures of economic uncertainty. We find that the resulting uncertainty betas explain a significant proportion of the cross-sectional dispersion in hedge fund returns. However, the same is not true for mutual funds, for which there is no significant relationship. After controlling for a large set of fund characteristics and risk factors considered in earlier work, the positive relation between uncertainty betas and future hedge fund returns remains economically and statistically significant. Hence, we argue that macroeconomic risk is a powerful determinant of cross-sectional differences in hedge fund returns. We also show that directional and semi-directional hedge fund managers have the ability to time macroeconomic changes by increasing (decreasing) their portfolios' exposure to macroeconomic risk factors when economic uncertainty is high (low). However, the same is not true for non-directional hedge funds and mutual funds, both of which lack significant macro-timing ability. Thus, the predictive power of uncertainty betas seems to arise from the ability of hedge funds to detect fluctuations in financial markets and to adjust their positions in a timely fashion as macroeconomic conditions change.

Keywords: hedge funds, mutual funds, macroeconomic risk, economic uncertainty

JEL Classification: G10, G11, C13