This paper investigates the extent to which market risk, residual risk, and tail risk explain the cross sectional dispersion in hedge fund returns. The paper introduces a comprehensive measure of systematic risk (SR) for individual hedge funds by breaking up total risk into systematic and fund specific or residual risk components.
Contrary to the popular understanding that hedge funds are ‘market neutral’ it finds that systematic risk is a highly significant factor explaining the dispersion of cross-sectional returns while at the same time measures of residual risk and tail risk seem to have little explanatory power.
Funds in the highest SR quintile generate 6 per cent more average annual returns compared to funds in the lowest SR quintile. After controlling for a large set of fund characteristics and risk factors, systematic risk remains positive and highly significant, whereas the relation between residual risk and future fund returns continues to be insignificant. Hence, systematic risk is a powerful determinant of the cross-sectional differences in hedge fund returns.