Abstract
Funds of hedge funds (FOFs) have been depicted as a type of conservative vehicle to many institutional and retail investors for accessing hedge fund investment. We challenge this view by investigating the role of tail risk exposure in FOFs. We find that the tail risk exposure determines a fund’s return and significantly influences a fund’s performance over one to three-month horizon. In particular, we find that the marginal extreme losses to one unit change of tail risk exposure in bear markets nearly double the marginal extreme gains in bull markets. This non-linear payoff structure must be evaluated carefully by anyone who wishes to invest in FOFs.
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