Do Hedge Funds Reduce Idiosyncratic Risk?

Namho Kang, Péter Kondor and Ronnie Sadka

Journal of Financial and Quantitative Analysis, 2014, vol. 49, issue 4, 843-877

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.

Date: 2014
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Working Paper: Do Hedge Funds Reduce Idiosyncratic Risk? (2012)
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