Do Hedge Funds Exploit Rare Disaster Concerns?

Abstract

We find hedge funds that have higher return covariation with a disaster concern index, which we develop through out-of-the-money puts on various economic sector indices, earn significantly higher returns in the cross section. We provide substantial evidence that these funds have better skills in exploiting the market's ex ante rare disaster concerns (SED), which may not realize as disaster shocks ex post. In particular, high-SED funds on average outperform low-SED funds by 0.96% per month, but have less exposure to disaster risk. They continue to deliver superior future performance when SED is estimated using the disaster concern index purged of disaster risk premium, and have leverage-managing and extreme-market-timing abilities. We also provide strong evidence against alternative interpretations.