Hedge fund tail risk : performance and hedging mechanisms
1University of Oulu, Oulu Business School, Department of Finance, Finance
|PDF Full Text (PDF, 1.9 MB)
The goal of this master’s thesis is to understand the performance implications of hedge fund’s tail risk, and the mechanisms of how some funds achieve lower tail risk. The current evidence on the performance implications is mixed, with most empirical hedge fund studies suggesting higher returns to higher risk. This is not obvious since the goal of skillful hedge fund managers is to deliver positive risk-adjusted returns, and indeed a few studies do report higher returns to lower risk. The issue is further complicated by the evidence of asset-level low-risk anomalies, which could create a low-skill alternative for managers to achieving higher returns with lower risk. Using a consolidation of commercial hedge fund databases, we decompose hedge fund tail risk, conditional on market distress, into two components: Systematic Conditional Tail Risk (SCTR) arising predictably via equity market exposure, and Idiosyncratic Conditional Tail Risk (ICTR) arising from unpredictable, proprietary alpha investment technology. First, using a subset of large, 13F-HR matched hedge funds from March 2000 to June 2013, we show that especially low-ICTR hedge funds deliver superior future risk-adjusted returns. In contrast to existing hedge fund literature our results support the broader view in asset-pricing literature that low risk is associated with higher risk-adjusted returns. The results are robust to the inclusion of additional risk factors, including a low-risk factor, suggesting that the better performance could be due to skillful hedging rather than harvesting of low-risk anomalies. This skill hypothesis is further supported by the finding that low-risk funds charge higher incentive fees, consistent with economic theory. To further resolve the puzzle of whether low-risk funds outperform high-risk funds, using a large set of funds from January 1994 to June 2013, we run a comprehensive “horse race” between our risk measures and a replication of a large array of existing risk measures. Our results show that for many existing risk measures, the purported risk premium largely diminishes when controlling fund size, suggesting that existing results may be somewhat driven by the inclusion of smaller funds. Our measures SCTR and ICTR consistently show low-risk funds outperforming high-risk funds. Second, using 13F-HR option holdings data from March 1999 to June 2013, we investigate the underlying hedging mechanism implemented by low tail risk hedge funds. We demonstrate that low-SCTR funds allocate a high fraction of their wealth — consistently over time — to protective option strategies, while low-ICTR funds use costly protective strategies only during the financial crisis. Funds with low ICTR also employ more stock, but not index, options, which fits the idiosyncratic nature of the measure. After the financial crisis, volatility-linked Exchange Traded Products (ETPs) have emerged as a potential alternative to hedging tail risk. We show that, from April 2009 to June 2013, the use of such volatility-linked ETPs is associated with lower SCTR but not ICTR, consistent with the option result, and indeed suggesting a complementary hedging mechanism.
© Mikko Kauppila, 2014. This publication is copyrighted. You may download, display and print it for your own personal use. Commercial use is prohibited.