Hedge Funds and the Positive Idiosyncratic Volatility Effect
59 Pages Posted: 12 Dec 2018 Last revised: 18 Jul 2023
Date Written: July 17, 2023
While it is established that idiosyncratic volatility has a negative impact on the cross-section of stock returns, this relation is largely unexplored for hedge funds. We document that hedge funds with high idiosyncratic volatility earn higher future risk-adjusted returns of 6% p.a. than hedge funds with low idiosyncratic volatility. The outperformance arises because hedge funds trade high idiosyncratic volatility stocks wisely. They pick high volatility stocks when they are underpriced and short-sell high volatility stocks when they are overpriced. Our results support the notion that hedge funds’ idiosyncratic volatility is a measure of managerial skill.
Keywords: Hedge Funds, Idiosyncratic Volatility Puzzle, Equity Portfolio Holdings, Short-Selling, Managerial Incentives, Investment Performance
JEL Classification: G11, G23
Suggested Citation: Suggested Citation