‘When There is no Place to Hide’: Correlation Riskand the Cross-Section of Hedge Fund Returns

This paper analyzes the relation between correlation risk and the cross-section of hedge fund returns.Legal framework and investment mandate imply that hedge funds can be severely exposed tocorrelation risk: Hedge funds ability to enter long-short positions can be useful to reduce marketbeta, but it can severely expose the fund to unexpected changes in correlations. Our empiricalstudy produces the following novel …findings to the literature. First, hedge funds´absolute returnsare explained to a statistically and economically signi…ficant percentage by exposure to correlationrisk. Second, different exposures to correlation risk explain cross-sectional differences in hedge fundexcess returns. Third, correlation risk is the only priced risk factor in the cross-section of hedgefund returns.[...]