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 decades.

Idiosyncratic Volatility, Institutional Ownership, and Investment Horizon

“…Our findings are of interest to various market participants. First, this paper makes important contributions to the literature connecting firm ownership structure and stock price volatility (e.g., Sias, 2004;Bushee and Noe, 2000;Koch et al, 2010;Greenwood and Thesmar, 2011;Kang et al, 2011). We provide evidence that (1) the cross-sectional relation between institutional ownership and IV is conditional on the type of institutional ownership and (2) there is a feedback effect between IV and types of institutional ownership.…”

“…Because 13F reporting is aggregated across different units within an institution, the number of institutions reflects the number of unrelated institutions buying or selling the security. 7 Kang et al (2011) show that the quarterly and monthly IV series display similar trends. 8 For our empirical tests, we present results that employ a scaled version of IV (the IV calculated as in equation (2), divided by the degrees of freedom in each estimated regression).…”

“…Dennis and Strickland (2004) provide additional support for this hypothesis, using a larger sample of firms. Kang et al (2011) focus on the cross-sectional distribution of idiosyncratic volatilities and find that the trading activity of hedge funds reduces the volatility of low-IV stocks but amplifies that of high-IV stocks.…”

The role of hedge funds in the asset pricing: evidence from China

“…Therefore, prices may deviate from fundamental values for a long time in the Chinese stock market, which limits professional investors' risk-bearing capacity (Shleifer and Vishny 1997). Kang, Kondor, and Sadka (2014) document that hedge funds might reduce their positions after a series of adverse shocks, which leads to the increased idiosyncratic volatility of high-idiosyncraticvolatility stocks and the decreased idiosyncratic volatility of low-idiosyncratic-volatility stocks. Jiang, Xu, and Yao (2009) show that the higher institutional ownership, the lower idiosyncratic volatility of stocks.…”

Investor attention and idiosyncratic risk in cryptocurrency markets

“…Since Ang et al (2006) presented their research results on the significant negative relationship between idiosyncratic risk and cross-sectional returns of stocks, the testing and analysis of idiosyncratic risk has become one of the hot issues in the field of asset pricing. For the last decade, many studies have been trying to find theoretical explanation and empirical evidence for such phenomena (Cao, Simin, and Zhao 2008;Fu 2009;Kang, Kondor, and Sadka 2014). Collectively, extant studies all argue that compared to systematic risk, idiosyncratic risk reflects the risk unique to the asset itself, which should be paid more attention to.…”