The response of hedge fund higher moment risk to macroeconomic and illiquidity shocks

Abstract

Risk related to return higher moments is usually perceived as substantial in the hedge fund industry. In this article, we relate the return co-skewness and co-kurtosis of hedge fund strategies to macroeconomic and financial shocks. We find that hedge funds’ return higher moments are quite sensitive to these shocks, and especially during the subprime crisis. Our robust IV-GMM estimation procedure reveals that output shocks are more important for explaining the co-kurtosis of most hedge fund strategies than shocks related to jumps in the VIX, while we find the opposite for co-skewness. This suggests that hedge funds better monitor their co-kurtosis. Our VAR experiments show that the bulk of the reaction of higher moment risk to shocks occurs during recessions. Furthermore, some directional strategies—like short-sellers and futures—successfully track shocks and deliver higher returns during periods of crisis, benefiting from market volatility analogously to lookback straddles. Our results also suggest that illiquidity factors are subject to endogeneity and may be viewed as indicators of return smoothing, especially during crises. Robustness checks show that the practice of return smoothing may lead to a serious underestimation of hedge fund higher moment systematic risk, and particularly fat-tail risk.