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.