Systemic Risk and Cross-Sectional Hedge Fund Returns

Abstract

This paper examines the cross-sectional relation between the systemic risk contribution of hedge funds and hedge fund returns. Measuring the systemic risk of an individual hedge fund by using the marginal expected shortfall (MES), we find evidence for a positive and statistically significant relation between systemic risk and hedge fund returns. The riskadjusted return of a hedge fund portfolio with a high systemic risk is 0.64% per month higher than for one with a low systemic risk during 1994–2012, while negative performance is observed during crisis periods. The relation between systemic risk and hedge fund returns holds for both live and defunct funds. Moreover, the relation holds even after controlling for a large set of fund characteristics. Hence, systemic risk is a powerful determinant of crosssectional variations in hedge fund returns. Because hedge funds with a high systemic risk contribution tend to have high downside beta, these results imply that investors are willing to demand a premium to carry tail risk during systemic events. JEL classification: G10, G11, G23, G28, C13.