Beta Uncertainty, Risk, and the Performance Characteristics of Hedge Funds

Beta Uncertainty, Risk, and the Performance Characteristics of Hedge Funds

Pradosh Simlai

Abstract

This study examines the empirical performance of aggregate hedge fund indices in the presence of beta uncertainty. We use a two-stage multifactor approach to generate risk premia of hedge funds returns and disentangle the common sources of beta uncertainty. We show that the actual estimate of hedge funds risk are severely understated and is related to the issue of non-synchronous pricing. Our finding directly indicates the existence of stale pricing in illiquid markets. We demonstrate a concise relationship between time-varying idiosyncratic volatility (IVOL) emanating from market portfolio and expected returns of individual hedge funds. Our results reveal that the hedge funds with high IVOL prefers growth firms characterized by low book-to-market ratios, and the hedge funds with low IVOL singles out small size firms. Overall, our key findings that the exposure to common risk factors and idiosyncratic component of market risk display strong predictive power for performance characterization of hedge funds significantly adds to the literature.

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