The Risk in Hedge Fund Strategies : Theory and

Theory suggests that long/short equity hedge funds’ returns come from long/short as well as directional exposure to the stock market and the fees related to stock loans. Empirical analysis finds persistent net exposures to the spread between small versus large cap stocks in addition to the overall market. Together, these factors account for over 80% of return variation. Additional factors are price momentum and market activity. After adjusting for the risks associated with marketable securities, excess performance is positive and correlate to aggregate short interest. In comparison, equity mutual funds and long-bias equity hedge funds have lower excess performance and are uncorrelated to market activity and/or aggregate short interest. Consistent with theory, long/short equity hedge funds appear to derive excess performance from privileged access to the stock loan market. * Fung is at the Centre for Hedge Fund Research and Education at the London Business School. Hsieh is at the Fuqua School of Business at Duke University. We acknowledge the LBS Centre for Hedge Fund Research and Education for providing the hedge fund data, and Mohan Gopalan for providing the short interest data in this paper. We also thank Ken French for the data from his website, Lubos Pastor and Robert Stambaugh for making their liquidity factor available, and Markus Brunnermeier and Stefan Nagel for making their Nasdaq “Tech” factor available. We received comments from seminar participants at Georgia State University and University of California at Irvine. We are responsible for any remaining errors.