Sentiment Risk and Hedge Fund Returns

This paper documents a new and important cross-sectional determinant of hedge fund returns, their exposures to sentiment risk, measured as beta of fund returns to fluctuations in sentiment proxies. For a large sample of equity-oriented hedge funds, those whose sentiment beta ranks in the top decile subsequently outperform the bottom decile by 0.67% per month, after controlling for fund’s exposures to existing risk factors. Sentiment risk is also priced in stocks, but it explains only a small friction of the abnormal return spread between high versus low sentiment-beta hedge funds. High sentiment-beta funds tend to increase their exposures to sentiment risk the most when doing so turns out to be profitable. This positive sentiment timing contributes to the abnormal performance of high sentiment-beta hedge funds.