Hedge Funds and the Positive Idiosyncratic Volatility Effect

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% 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.