Disagreement exploitation and the cross‐section of hedge fund performance

Abstract This study examines the role of market disagreement in explaining the cross‐section of hedge fund performance. In a market where disagreement fluctuates, skilled arbitrageurs may employ trading strategies to exploit the mispricing caused by disagreement and short‐sale constraints. Skilled hedge funds with high sensitivity to disagreement can take advantage of mispricing in high‐disagreement periods to improve their performance. We show that hedge funds with a high disagreement beta tend to possess skill in exploiting disagreement and, as such, they can earn higher cross‐sectional returns compared to other hedge funds lacking this skill. Existing risk factors and a tradable disagreement factor do not fully explain the difference in hedge fund performance between those with high and low disagreement betas. Further evidence shows that experienced hedge funds and hedge funds that charge a high incentive fee are likely to have high disagreement betas. Our empirical findings are robust in using various disagreement measures and methodologies to estimate disagreement beta.