The Risk of Funds of Hedge Funds: An Empirical Analysis of the Maximum Drawdown

Abstract

Funds of hedge funds (FHF) are perceived to be the premier choice for institutional investors looking to enter the alternative investment asset class. This article empirically investigates the maximum drawdowns of FHF. It analyzes the time series and descriptive variables of 649 FHFs from the Lipper TASS Hedge Fund database for January 1996 through August 2007. The empirical results suggest 1) the number and the magnitude of drawdowns decreases as the experience of the FHF increases, 2) the average recovery time is higher for older FHFs, 3) there is no difference between small and large FHFs in regards to the magnitude of a maximum drawdown, 4) the higher a maximum drawdown of a FHF, the longer it takes to recover, and 5) most maximum drawdowns occur during times of financial market turmoil. Thus, our findings question especially the acclaimed ability of FHFs to deliver absolute returns. We also show that the beta risks involved with FHFs are high. We find that the advantages of FHFs are more likely to be in their low long-term correlations with traditional asset classes, as well as in their low volatility. <b>TOPICS:</b>Real assets/alternative investments/private equity, risk management, performance measurement