Risks and Portfolio Decisions Involving Hedge Funds

Abstract

This article characterizes the systematic risk exposures of hedge funds using buy-and-hold and option-based strategies. Our results show that a large number of equity-oriented hedge fund strategies exhibit payoffs resembling a short position in a put option on the market index and therefore bear significant left-tail risk, risk that is ignored by the commonly used mean-variance framework. Using a mean-conditional value-at-risk framework, we demonstrate the extent to which the mean-variance framework underestimates the tail risk. Finally, working with the systematic risk exposures of hedge funds, we show that their recent performance appears significantly better than their long-run performance. It is well accepted that the world of financial securities is a multifactor world consisting of different risk factors, each associated with its own factor risk premium, and that no single investment strategy can span the entire ‘‘risk factor space.’’ Therefore investors wishing to earn risk premia associated with different risk factors need to employ different kinds of investment strategies. Sophisticated investors, like endowments and pension funds, seem to have recognized this fact as their portfolios consist