Investor Sentiment and the Pricing of Macro Risks for Hedge Funds

Hedge funds with larger macroeconomic-risk betas do not earn higher returns, in contrast to the theoretically predicted risk-return trade-off. Meanwhile, high macro-beta funds deliver higher returns than low macro-beta funds following low-sentiment months, whereas the risk-return relation is flat following high-sentiment months. Our findings are consistent with the conjecture that standard asset pricing theory is still at work when market participants are rational. On the other hand, sophisticatedly managed portfolios including hedge funds are likely to be affected by sentiment-induced mispricing, especially for those with high macro-risk loadings. Fund flows and fund managers' sentiment timing are possible driving forces underlying the observed pattern.