Hedge Funds and the Positive Idiosyncratic Volatility Effect

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. They pick high volatility stocks when they are undervalued or when they experience positive earnings surprises in the future. They shy away from high volatility stocks when they are overvalued or when they display lottery-like payoffs. Hedge funds also trade derivatives in a way to profit from the positive volatility effect.

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

JEL Classification: G11, G23