Investor Behavior, Hedge Fund Returns and Strategies

We quantify risks associated with investor behavior using several asset pricing models and hedge fund data. After finding that irrational sentiments play a role in hedge fund returns, our multi-beta CAPM estimations reveal that beta belonging to irrational component varies around .037 for risky hedge funds and .018 for relatively less risky ones. Investors can use this irrational beta to gauge the extent of irrational sentiments prevailing in markets and compare the values in turbulent periods with more tranquil periods to re-adjust their portfolios and use these betas as an early warning sign of future trends. It can also guide investors in avoiding those funds that display greater irrational behavior. Our approach offers investors a solid quantitative rather than subjective approach in assessing the oncoming of a financial downturn and in doing so better protect against unpredicted losses that may result from irrational trading.