Recent literature implies that despite being more diversified, fund of hedge funds (FOFs) are exposed to tail risk. We propose an explanation for this phenomenon; tail risk is a systematic risk factor for hedge funds, which by construction, explains the higher portion of the returns in the diversified portfolios. Our study suggests that not only an additional tail risk factor improves the explanatory power of the factor model, the relative importance of tail risk factor increases with the number of underlying hedge funds in an FOF portfolio. Furthermore, we demonstrate that FOFs with a short history, higher management fees, leverage and requiring shorter lockup periods are more sensitive to tail risk.

The Consumer Sentiment Index (CSI) is a widely monitored economic indicator. The index measures consumer expectations, which contain information about potential future changes in consumer spending. Thus, any change in the dynamics of the sentiment index should contain important signals about future consumer behaviour, as well as changes in the real economy and stock returns. In this paper we use Cox’s proportional hazards model to estimate dynamic transition probabilities for a reversal in the CSI. We predict the probability of both positive and negative runs in sentiment surviving in the same state. Lagged changes in consumer sentiment and the frequency of recent reversals of sentiment are found to be significant predictors of a change in state. The model has substantial predictive ability, as measured by both categorical accuracy and a probability scoring rule, the Brier Score (Brier, 1950) out of sample. The predictive accuracy of the model is robust to the impact of the global financial crisis.

Prior studies found that analyst forecast dispersion predicts future market returns. Some prior studies attribute this predictability to the short-sale constraints in the market according to the overpricing theory. Using the U.S. data from 1981 to 2014, we find that the return predictive power of aggregate dispersion only exists prior to 2005. The investor sentiment index, as a proxy of short-sale constraints used by many studies, can only explain the dispersion effect prior to 2005. The investor sentiment index and other proxies such as institutional ownership and put options cannot explain the significant weakening of the dispersion effect after the global financial crisis. We argue that the dispersion-return relation is partly driven by the correlation between dispersion and conditional equity premium. Our evidence suggests that the short-sale constrained stocks do not experience a higher dispersion effect, which is contrary to what the overpricing theory predicts.