Hedge Funds and the Positive Idiosyncratic Volatility Effect

60 Pages Posted: 12 Dec 2018 Last revised: 18 Dec 2020

See all articles by Turan G. Bali

Turan G. Bali

Georgetown University - Robert Emmett McDonough School of Business

Florian Weigert

University of Neuchatel - Institute of Financial Analysis; University of Cologne - Centre for Financial Research (CFR)

Date Written: December 1, 2020

Abstract

While it is established that idiosyncratic volatility has a negative impact on the cross-section of future stock returns, the relationship between idiosyncratic volatility and future hedge fund returns is largely unexplored. We document that hedge funds with high idiosyncratic volatility outperform and this pattern is explained by the positive return effect of idiosyncratic volatility in their equity portfolio holdings. Hedge funds select stocks wisely by picking high-volatility stocks when they are undervalued and shying away from high-volatility stocks when they are overvalued or display lottery-like payoffs. They also trade derivatives in a way to profit from the positive volatility effect.

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, Hedge Funds and the Positive Idiosyncratic Volatility Effect (December 1, 2020). 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 Neuchatel - Institute of Financial Analysis ( email )

Pierre-a-Mazel,7
Neuchatel, CH-2000
Switzerland

University of Cologne - Centre for Financial Research (CFR) ( email )

Albertus-Magnus Platz
Cologne, 50923
Germany

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