Investor Sentiment and the Pricing of Macro Risks for Hedge Funds

Abstract

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 a low-sentiment period, whereas the risk-return relation is flat following a high-sentiment period. We show that the sophisticated management of hedge funds explains this pattern. The relation between funds’ macro-risk betas and the timing abilities/investor flows is sentiment dependent, and such variation likely drives the contrasting beta-return trade-offs after high- and low-sentiment periods. A similar pattern is also observed in mutual funds. This paper was accepted by Lin William Cong, finance. Funding: X. Zhu acknowledges financial support from the National Natural Science Foundation of China [Grant 72203035] and the Ministry of Education Project of Humanities and Social Sciences [Grant 22YJC790194]. Z. Chen acknowledges financial support from the National Natural Science Foundation of China [Grant 72222004] and Tsinghua University [Grant 20225080020]. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2022.02792 .