Have Hedge Funds Solved the Idiosyncratic Volatility Puzzle?

58 Pages Posted: 12 Dec 2018 Last revised: 14 May 2019

See all articles by Turan G. Bali

Turan G. Bali

Georgetown University - Robert Emmett McDonough School of Business

Florian Weigert

University of St. Gallen - School of Finance

Date Written: March 2019

Abstract

This paper examines idiosyncratic volatility of equity-oriented hedge funds and provides an explanation for why there exists a positive cross-sectional relation between funds’ idiosyncratic volatility and their future returns, whereas higher idiosyncratic volatility predicts lower returns in the cross-section of individual stocks. We find that idiosyncratic volatility is a persistent hedge fund characteristic and positively linked to proxies for managerial incentives, discretion, and leverage. Moreover, funds with a greater value of long call options and confidential equity positions disclosed with a delay in their regulatory filings exhibit higher idiosyncratic volatility. We document a positive (negative) cross-sectional relation between idiosyncratic volatility and future returns on individual stocks with high (low) hedge fund ownership. The results indicate that hedge funds are able to solve the idiosyncratic volatility puzzle by successfully picking undervalued, high-volatility stocks that offer high future returns and shying away from overvalued, high-volatility and lottery-like stocks that offer low future returns.

Keywords: Hedge Funds, Idiosyncratic Volatility Puzzle, Confidential Holdings, Derivatives, Managerial Incentives, Investment Performance

JEL Classification: G11, G23

Suggested Citation

Bali, Turan G. and Weigert, Florian, Have Hedge Funds Solved the Idiosyncratic Volatility Puzzle? (March 2019). Georgetown McDonough School of Business Research Paper No. 3292347; University of St.Gallen, School of Finance Research Paper. Available at SSRN: https://ssrn.com/abstract=3292347 or http://dx.doi.org/10.2139/ssrn.3292347

Turan G. Bali

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: https://sites.google.com/a/georgetown.edu/turan-bali

Florian Weigert (Contact Author)

University of St. Gallen - School of Finance ( email )

Unterer Graben 21
St.Gallen, CH-9000
Switzerland

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