Do Hedge Funds Reduce Idiosyncratic Risk?

Abstract

This paper studies the effect of hedge-fund trading on idiosyncratic risk. We hypothesize that while hedge-fund activity would often reduce idiosyncratic risk, high initial levels of idiosyncratic risk might be further amplified due to fund loss limits. Panel-regression analyses provide supporting evidence for this hypothesis. The results are robust to sample selection and are further corroborated by a natural experiment using the Lehman bankruptcy as an exogenous adverse shock to hedge-fund trading. Hedge-fund capital also explains the increased idiosyncratic volatility of high-idiosyncratic-volatility stocks as well as the decreased idiosyncratic volatility of low-idiosyncratic-volatility stocks over the past few decade. 1 We formalize our hypothesis in a stylized model whereby professional traders engage in long-short positions to profit from the mean reversion of non-fundamental shocks subject to traders' limited loss-bearing capacity. The model is presented in Appendix D.2 The loss limit can come from various sources, including internal or external value-at-risk (VAR) constraints, wealth effects, constraints on equity or debt, margin requirements or expected or realized fund-flow response to poor performance. See the related theoretical (e.g.

Too big to ignore? Hedge fund flows and bond yields

“…In particular, Kruttli et al (2015) show that the aggregate liquidity of hedge funds, proxied by the average hedge fund return serial correlation coefficient, has predictive power for future returns on stock, bond, and currency indices. Kang et al (2014) link hedge fund trading and stock-idiosyncratic volatility. Choi et al (2010) investigate convertible bond issuance and convertible bond arbitrage hedge funds.…”

Structural holes and hedge fund return comovement: evidence from network‐connected stock hedge funds in China

“…The social network of hedge fund managers covers a wide range of aspects, including college alumni, colleagues, association members, etc. Different from the social connections through business relationships, alumni connections are not business‐related and are more likely to form a sense of trust and empathy (Zou and Ingram, ; Ingram and Zou, ; Kang et al ., ). It is common that many fund managers are graduates from the same top universities, and there are various alumni networks in the financial markets that provide a channel for alumni with various resources to share information with each other (Kuhnen, ; Fracassi and Tate, ).…”

Disagreement between hedge funds and other institutional investors and the cross‐section of expected stock returns

“…For this, we compute the future returns to bivariate portfolios created by independently sorting stocks based on hedge fund and non-hedge fund trading in each quarter. We find that stocks heavily bought by hedge funds and contemporaneously heavily sold by non-hedge funds (i.e., disagreement stocks) earn 0.47% (t-stat = 7.55) characteristic-adjusted monthly return and 0.54% (t-stat = 5.97) four-factor monthly alpha over the 1 One part of the literature that studies how hedge funds trade in stock markets in a more general manner include Brunnermeier and Nagel (2004), and Kang et al (2014). Moreover, while there are some studies that focus on how hedge funds contribute to market efficiency (e.g., Akbas et al, 2015;Caglayan et al, 2018;, other studies show that institutional investors as a whole group exacerbate mispricings (Jiang, 2010;Edelen et al, 2016).…”