Hedge Funds and the Positive Idiosyncratic Volatility Effect

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

Bali, Turan G. and Weigert, Florian, Hedge Funds and the Positive Idiosyncratic Volatility Effect (July 17, 2023). 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