Failure Risk and the Cross-Section of Hedge Fund Returns

Posted: 8 Jan 2009

Date Written: January 7, 2009

Abstract

On average, hedge funds fail slowly rather than through sudden crashes. I model a fund's probability of failure using a dynamic logit regression and find that fund failures are predicted by past performance and fund flows measured with a lag of seven months. Hedge funds fail as poor performance over a period of time leads to fund withdrawals by investors. A fund's failure risk predicts negatively the fund's future returns. Sorting hedge funds into quintiles by the predicted failure probability based on information lagged by seven months, I find that the return spread between the two extreme quintiles is 7.6~8.9% per year after adjusting for nine commonly used hedge fund risk factors and a return smoothing effect over the period of July 1996 to September 2007. The negative failure risk effect on future fund returns is sharply higher for funds with weak share restrictions and is not subsumed by the findings of the prior literature.

Suggested Citation

Kim, Jung-Min, Failure Risk and the Cross-Section of Hedge Fund Returns (January 7, 2009). Available at SSRN: https://ssrn.com/abstract=1324341 or http://dx.doi.org/10.2139/ssrn.1324341

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