Volatility of aggregate volatility and hedge funds returns

This paper investigates empirically whether uncertainty about the expected returns on the market portfolio can explain the performance of hedge funds both in the cross-section and over time. We measure uncertainty via volatility of aggregate volatility (VOV) and construct an investable version of this measure by computing monthly returns on lookback straddles written on the VIX index. We find that VOV exposure is a significant determinant of hedge fund returns at the overall index level, at different strategy levels, and at an individual fund level. We find that funds with low (more negative) VOV betas outperform funds with high VOV betas by 1.62% per month. After controlling for a large set of fund characteristics, we document a robust and significant negative risk premium for VOV exposure in the crosssection of hedge fund returns. We further show that strategies with less negative VOV betas outperform their counterparts during the financial crisis period when uncertainty about expected returns was at its highest. On the contrary, strategies with more negative VOV betas generate superior returns when uncertainty in the market is less. Furthermore, the variation in the VOV betas is consistent with the risk-taking incentives of hedge funds arising from the different fund characteristics including their contractual features.