|Zero-R2 Hedge Funds and Market Neutrality
|Journal of Financial and Quantitative Analysis, forthcoming 2012
Factor models yield an R2 insignificantly different from zero for one-third of hedge funds in a broad sample. These funds illustrate the concept
of market neutrality and feature lower volatilities, higher Sharpe ratios, and higher alphas than other funds, indicating they provide a successful
alternative investment. However, large portfolios of zero-R2 funds contain fully half the volatility of portfolios of other funds, suggesting they
feature substantial systematic risk. Furthermore, these funds display an increased probability of failure even after controlling for idiosyncratic
volatility. These results indicate the presence of an omitted factor that exposes investors to significant downside risk.