Risks and Portfolio Decisions Involving Hedge Funds

Abstract:     
This paper characterizes the systematic risk exposures of hedge funds using buy-and-hold and option-based strategies. 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. Finally, working with the systematic risk exposures of hedge funds, we show that their recent performance appears significantly better than their long-run performance.

Keywords: hedge funds, option-based trading strategies, conditional Value-at-Risk, tail risk and multifactor models

JEL Classification: G10, G19

Accepted Paper Series