Financial Intermediary Risk and the Cross-section of Hedge-fund Returns

Abstract

We find that systematic financial intermediary risk, measured by the covariation between fund returns and shocks to the equity capital ratio of key financial intermediaries - New York Federal Reserve Primary Dealers - is a strong determinant of the cross-section of hedge fund returns. A portfolio of hedge funds with high financial intermediary risk exposure outperforms, on average, a low-exposure portfolio by approximately 7% per year on a risk-adjusted basis. This positive relationship remains robust after controlling for a comprehensive set of fund characteristics and other risk factors known to influence the cross-section of hedge fund returns.

Keywords: Intermediary risk, systematic risk, hedge funds

JEL Classification: G12, G23, G24