Hedge funds and the positive idiosyncratic volatility effect

Turan G. Bali and Florian Weigert

Review of Finance, 2024, vol. 28, issue 5, 1611-1661

Abstract: While it is established that idiosyncratic volatility is negatively priced in the cross-section of stock returns, the relation between idiosyncratic volatility and hedge fund returns is largely unexplored. We document that hedge funds with high idiosyncratic volatility earn higher future risk-adjusted returns of 6 percent p.a. than hedge funds with low idiosyncratic volatility. The outperformance arises because hedge funds trade high idiosyncratic volatility stocks wisely. They pick high volatility stocks when they are underpriced and short-sell high volatility stocks when they are overpriced. Our results support the notion that hedge funds’ idiosyncratic volatility is a measure of managerial skill.

Keywords: hedge funds; idiosyncratic volatility puzzle; equity portfolio holdings; short-selling; managerial incentives; investment performance (search for similar items in EconPapers)
JEL-codes: G11 G23 (search for similar items in EconPapers)
Date: 2024
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