When There is No Place to Hide - Correlation Risk and the Cross-Section of Hedge Fund Returns

Abstract:     
Using a novel dataset of correlation swap quotes, we study the relation between correlation risk, hedge fund characteristics and their risk-return profile. First, we find that hedge funds' ability to create market neutral returns is often associated with a significant exposure to correlation risk. Second, exposure to correlation risk explains large biases in risk-adjusted performance rankings between funds, with respect to benchmark valuation frameworks with no correlation risk dimension. Third, we estimate a significant negative market price of correlation risk, which explains a large part of the cross-section of hedge fund excess returns with their correlation risk exposure. Finally, we detect a pronounced nonlinear relation between correlation risk exposure and the tail risk of hedge fund returns.

Number of Pages in PDF File: 46

Keywords: Stochastic Correlation and Volatility, Hedge Fund Performance, Optimal Portfolio Choice

JEL Classification: D9, E3, E4, G11, G14, G23

working papers series