Risks and portfolio decisions involving hedge funds

Finance

IFA Working Paper

Agarwal V;Naik N Y

Narayan Naik

2002

Hedge funds are known to exhibit non-linear option-like exposures to standard asset classes and therefore the traditional linear factor model provides limited help in capturing their risk-return tradeoffs. We address this problem by augmenting the traditional model with option-based risk factors. Our results show that a large number of equity-oriented hedge fund strategies exhibit payoffs resembling a short position in a put option on the market index, and therefore bear significant left-tail risk, risk that is ignored by the commonly used mean-variance framework. Using a mean-conditional Value-at-Risk framework, we demonstrate the extent to which the mean-variance framework underestimates the tail risk. Working with the underlying systematic risk factors, we compare the long-run performance with the recent performance of hedge funds and find that their recent performance appears significantly better than their long-run performance. Our analysis provides important insights that can be helpful in addressing issues like construction of fund of funds, risk management, benchmark design and manager compensation involving hedge funds.

Institute of Finance and Accounting

FIN 364

IFA Working Paper

No