While it is established that idiosyncratic volatility is negatively priced in the cross-section of stock returns, the relation between idiosyncratic volatility and hedge fund returns is largely unexplored. We document that hedge funds with high idiosyncratic volatility earn higher future risk-adjusted returns of 6 percent p.a. than hedge funds with low idiosyncratic volatility. The outperformance arises because hedge funds trade high idiosyncratic volatility stocks wisely. They pick high volatility stocks when they are underpriced and short-sell high volatility stocks when they are overpriced. Our results support the notion that hedge funds’ idiosyncratic volatility is a measure of managerial skill.

This paper investigates the risk versus mispricing explanation of superior returns to contrarian strategies using the interactions between value-to-market indicators and corporate financing transactions that increase or decrease a firm's outstanding equity. Portfolio-level analyses and firm-level cross-sectional regressions indicate that the well-documented contrarian profits soar when value stocks which repurchase shares (value repurchasers) and growth stocks which issue shares (growth issuers) are considered. Various risk measures indicate that value repurchasers are not riskier than growth issuers. Furthermore, time-series of realized growth rates, analysts' long-term growth estimates, and sensitivity of portfolio returns to investor sentiment support the misvaluation explanation.