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Abstract:
This paper compares downside risk measures that incorporate higher return moments with traditional risk measures such as standard deviation in predicting hedge fund failure. When controlling for styles, performance, fund age, size, lockup, high-water mark, and leverage, we find that funds with larger downside risk have a higher hazard rate. However, standard deviation loses the explanatory power once the other explanatory variables are included in the hazard model. Further, we find liquidation does not necessarily mean failure in the hedge fund industry. By reexamining the attrition rate, we show that the real failure rate of 3.1% is lower than the attrition rate of 8.7% on an annual basis from the period of 1995-2004.

hedge fund failure, downside risk, expected shortfall, VaR, attrition rate

Abstract:
This paper analyses the risk-return trade-off in the hedge fund industry. We compare semi-deviation, value-at-risk (VaR), Expected Shortfall (ES) and Tail Risk (TR) with standard deviation at the individual fund level as well as the portfolio level. Using the Fama and French (1992) methodology and the combined live and defunct hedge fund data from TASS, we find that the left-tail risk captured by Expected Shortfall (ES) and Tail Risk (TR) explains the cross-sectional variation in hedge fund returns very well, while the other risk measures provide statistically insignificant or marginally significant results. During the period between January 1995 and December 2004, hedge funds with high ES outperform those with low ES by an annual return difference of 7%. We provide empirical evidence on the theoretical argument by Artzner et al. (1999) that ES is superior to VaR as a downside risk measure. We also find the Cornish-Fisher (1937) expansion is superior to the nonparametric method in estimating ES and TR.

Abstract:
This paper analyzes the risk-return trade-off in the hedge fund industry. We compare semi-deviation, value-at-risk (VaR), Expected Shortfall (ES), and Tail Risk (TR) with standard deviation at the individual fund level as well as the portfolio level. Using the Fama and French (1992) methodology and the combined live and defunct hedge fund data from TASS, we find that the left-tail risk captured by the Expected Shortfall (ES) and Tail Risk (TR) explains the cross-sectional variation in hedge fund returns very well, while the other risk measures provide statistically insignificant or marginally significant results. During the period between January 1995 and December 2004, hedge funds with high ES outperform those with low ES by an annual return difference of 7%. We provide empirical evidence on the theoretical argument by Artzner et al. (1999) that ES is superior to VaR as a downside risk measure. We also find the Cornish-Fisher (1937) expansion is superior to the nonparametric method in estimating ES and TR.

hedge funds, cross-section of expected returns, conditional VaR, downside risk, Cornish-Fisher expansion

Abstract:
This paper examines share restrictions and liquidity premium by comparing offshore hedge funds with onshore hedge funds. Due to tax provisions and regulatory concerns, offshore and onshore hedge funds have different legal structures, which lead to differences in share restrictions such as the lockup provision. On average, offshore funds impose less severe share restrictions than onshore funds, hence underperforming their onshore counterparts due to illiquidity premium, consistent with Aragon (2007).

However, we find that once offshore funds impose share restrictions the illiquidity premium is higher because of a tighter relation between share illiquidity and asset illiquidity in the offshore fund portfolio. We show that onshore lockup funds are not necessarily holding illiquid assets, and the higher illiquidity of assets in offshore lockup funds is significant at 1 percent level. Hence introducing the lockup provision increases the abnormal return by 4.4% per year for offshore funds compared with only 2.7% for onshore funds during the period of 1994-2005.

We also examine the impact of a master-feeder (MF) structure on the difference between offshore funds and onshore funds. The MF structure is devised for hedge fund managers who wish to market a fund to both onshore and offshore investors. Instead of managing two different portfolios, the manager usually sets up one master company and two feeders. One feeder is a limited partnership for onshore investors and the other feeder is an offshore corporation for offshore investors. The actual portfolio investment is made at the master company level. We find that share illiquidity premium becomes lower when an offshore fund is affected by its onshore equivalence through a master-feeder structure.

In addition to the lockup provision, we examine other share restrictions such as redemption notice period, redemption frequency, subscription frequency and minimum investment, and the results are similar. The risk-adjusted return is higher in offshore funds than onshore funds when the same amount of a share restriction is introduced because the relation between share illiquidity and asset illiquidity is stronger in offshore funds.

Our findings have implications on the welfare of hedge fund investors. In addition to the tax advantage, offshore investors may collect higher illiquidity premium when their investment has the same level of share illiquidity as the investment of onshore investors. Our results may help explaining why the growth rate has been much higher in offshore funds than in onshore funds (26.4 vs. 15.0 percent per year from 2000 to 2004).

offshore hedge funds, share restrictions, liquidity premium, master-feeder structure