Systematic risk and the cross section of hedge fund returns

Abstract

Contrary to the theoretical principle that higher risk is compensated with higher expected return, the literature shows that low-risk stocks outperform high-risk stocks. Using a large-scale household dataset, we provide an explanation for this puzzling result that the anomalous negative risk-return relation is only confined to those stocks predominantly held by rich households, whereas the anomaly disappears for stocks held by non-rich households and institutional investors. We find that social status concern of rich households and the induced lottery preference explain wealthy investors’ demand for high-risk stocks, leading to overpricing and low future returns for such stocks.