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J. Joenvaara, M. Kauppila, “Hedge Fund Tail Risk: Performance and Hedging Mechanisms,” (working paper series)

J. Joenvaara, M. Kauppila, “Hedge Fund Tail Risk: Performance and Hedging Mechanisms,” (working paper series)

Abstract: We decompose hedge fund tail risk into two components: Systematic Conditional Tail Risk (SCTR), which arises predictably from equity market exposure; and Idiosyncratic Conditional Tail Risk (ICTR), which arises from proprietary alpha investment technology. First, we show that low-SCTR hedge funds deliver superior risk-adjusted returns, but not average returns. In contrast, low-ICTR funds provide both higher risk-adjusted returns and also higher average returns. Our results suggest that this better performance could be due more to skillful hedging than to the harvesting of low-risk anomalies. Second, we use option holdings data not available in commercial databases to investigate the hedging mechanism implemented by low-tail risk hedge funds. We demonstrate that low-SCTR funds consistently over time allocate much of their wealth to protective option strategies whereas low-ICTR funds use costly protective strategies only during the 2008 financial crisis. Funds with low ICTR also employ more stock (but not index) options to pick stocks; this is in line with the measure’s idiosyncratic nature. In line with the options result, we also find that post-crisis use of novel volatility-linked Exchange Traded Products is also associated with lower SCTR but not ICTR, which indicates a complementary hedging mechanism.