Bear Market Risk and the Cross-Section of Hedge Fund Returns

Abstract

We examine the presence of a premium for bear market risk – innovation in the probability of future bear market states – in the cross-section of hedge fund returns. Bear beta, the sensitivity of hedge funds to returns of a bear spread portfolio controlling for the market, is a direct way to classify funds as insurance buyers or sellers. We find that low bear beta funds (insurance sellers) outperform high bear beta funds (insurance buyers) by 0.58% per month on average, outperform even during market crashes, but underperform when bear market risk is realized. This contradicts the conventional belief that insurance sellers should be more exposed to realized crash risk.

Keywords: hedge funds, bear market risk, bear beta, Bear factor, market-hedged Bear factor

JEL Classification: G11, G12, G23