Do Hedge Funds’ Exposures to Risk Factors Predict Their Future Returns?

This paper investigates hedge funds’ exposures to various financial and macroeconomic risk factors through alternative measures of factor betas and examines the performance of these factor betas in predicting the cross-sectional variation in hedge fund returns. The results indicate a positive and significant link between default premium beta (DEF beta) and future hedge fund returns as well as a negative and significant link between inflation beta (INF beta) and future hedge fund returns. Hedge funds in the highest DEF beta quintile generate 5.8% more annual raw and risk-adjusted returns compared to funds in the lowest DEF beta quintile. Similarly, the annual average raw and riskadjusted returns of funds in the lowest INF beta quintile are 5% higher than the annual average returns of funds in the highest INF beta quintile. After controlling for Fama-French-Carhart’s four factors of market, size, book-to-market, and momentum as well as Fung-Hsieh’s five trend-following factors in stocks, short-term interest rates, currencies, bonds, and commodities, the positive relation between DEF beta and future hedge fund returns, as well as the negative relation between INF beta and future hedge fund returns remain economically and statistically significant. This Version: February 2010