Idiosyncratic Risk and Performance
of Hedge Funds

Abstract

Our research identifies a pattern in the idiosyncratic risks of hedge funds’ performance; that is, idiosyncratic risks tend to increase when the market is in a downturn. This result indicates that hedge fund managers may voluntarily decide the level of activeness in applying hedge fund strategies responding to various market situations. This research result indicates that change of alpha and beta in hedge fund performance may not be caused by the impersistence of investment skills of hedge fund managers, but rather by the change of activeness of hedge fund strategies. We also identify a structural change in the contribution of idiosyncratic risks to hedge fund performance in the market downturn caused by the burst of the high-tech bubble in 2001–2002. Prior to the downturn, idiosyncratic risk contributed negatively to excess return, whereas after the downturn, it contributed positively.