Idiosyncratic Risk and Cross Section of Hedge Fund Returns

This paper examines the extent to which idiosyncratic risk measures explain cross-sectional differences in hedge fund returns. Using exponential GARCH models to estimate conditional idiosyncratic volatility, we find a significant positive relation between conditional idiosyncratic volatility (E(IVOL)) and expected hedge fund returns. The portfolio of hedge funds with highest E(IVOL) outperforms that with the lowest E(IVOL) by 0.65% per month (7.8% per annum), over the period January 1998 to December 2011. This relation remains positive and highly significant after controlling for fund characteristics and momentum effects. Idiosyncratic risk is a powerful factor in explaining the cross-sectional variation in hedge fund returns