Abstract
Purpose - The purpose of this paper is to investigate to what extent hedge funds are subject to irrationality in their investment decisions. The authors advance the hypothesis that irrational behavior affects hedge fund returns despite their sophistication and active management style.
Design/methodology/approach - The irrational component may follow a pattern consistent with the observed hedge fund returns yet far distant from market fundamentals. The authors include factors beyond the original version of capital asset pricing model such as Fama and French and Carhart models, as well as less stringent models, such as APT and Fung and Hsieh, to test whether these models are able to capture the irrational nature of the residuals.
Findings - After finding that institutional irrational sentiments play a role in hedge fund returns, we note that the returns are not completely shielded against irrational trading; however, hedge fund returns appear to be affected only by the irrational component derived from institutional trading rather than that emanated from individuals.
Research limitations/implications - Different sources of irrationality may have asymmetric effects on hedge fund returns. Using a different set of sophisticated investors along with different market sentiment proxies may yield different results.
Practical implications - The authors argue that investors can use irrational beta to gauge the extent of institutional irrational sentiments prevailing in markets for the purpose of re-adjusting their portfolios and therefore use the betas as an early warning sign. It can also guide investors in avoiding funds and strategies that display greater irrational behavior.
Originality/value - The study advance the idea that the unexpected, hereafter irrational, component may follow a pattern consistent with the observed hedge fund returns, yet different from market fundamentals.