Tail Risk and Hedge Fund Returns

42 Pages Posted: 31 May 2012 Last revised: 20 Nov 2012

See all articles by Bryan T. Kelly

Bryan T. Kelly

Yale SOM; AQR Capital Management, LLC; National Bureau of Economic Research (NBER)

Hao Jiang

Michigan State University

Date Written: November 1, 2012


We document large, persistent exposures of hedge funds to downside tail risk. For instance, the hardest hit hedge funds in the 1998 crisis also suffered predictably worse returns than their peers in 2007-2008. Using the conditional tail risk factor derived by Kelly (2012), we find that tail risk is a key driver of hedge fund returns in both the time-series and cross-section. A positive one standard deviation shock to tail risk is associated with a contemporaneous decline of 2.88% per year in the value of the aggregate hedge fund portfolio. In the cross-section, funds that lose value during high tail risk episodes earn average annual returns more than 6% higher than funds that are tail risk-hedged, controlling for commonly used hedge fund factors. These results are consistent with the notion that a significant component of hedge fund returns can be viewed as compensation for selling disaster insurance.

Keywords: Hedge fund, tail risk, performance evaluation

JEL Classification: G12, G20

Suggested Citation

Kelly, Bryan T. and Jiang, Hao, Tail Risk and Hedge Fund Returns (November 1, 2012). Chicago Booth Research Paper No. 12-44, Fama-Miller Working Paper, Available at SSRN: https://ssrn.com/abstract=2019482 or http://dx.doi.org/10.2139/ssrn.2019482

Bryan T. Kelly (Contact Author)

Yale SOM ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Hao Jiang

Michigan State University ( email )

315 Eppley Center
Department of Finance
East Lansing, MI 48824
United States

HOME PAGE: http://sites.google.com/site/haojiangfinance/

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