Skewness Preference in Financial Markets

Abstract

Studies on the importance of skewness for investors find a negative relation between the risk premium and skewness, implying preference for positive skewness. Hedge funds (or money managers in general), however, acting as agents, may have preference for negative skewness as it would mean frequent returns and thus bonuses and more importantly survival at the job. I study skewness preferences of hedge funds and small, retail investors. I find a negative relation between the risk premium and a robust skewness measure for an index of small-cap stocks and one of the oldest closed-end funds, both of which tend to have a higher proportion of retail ownership, suggesting preference for positive skewness. For a hedge fund index, on the other hand, I find a positive relation, suggesting preference for negative skewness. In time periods when skewness is positive, hedge funds have a stronger preference for negative skewness, indicative of their strong aversion to skewness. These results suggest that skewness preference in financial markets need not always be for positive skewness, which seems to be the general consensus in the literature, once the agency problem and survival and compensation motives of money managers are recognized.