Risks and Portfolio Decisions Involving Hedge Funds

Posted: 21 Apr 2003  

Vikas Agarwal

Georgia State University; University of Cologne - Centre for Financial Research (CFR)

Narayan Y. Naik

London Business School - Institute of Finance and Accounting

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

Suggested Citation

Agarwal, Vikas and Naik, Narayan Y., Risks and Portfolio Decisions Involving Hedge Funds. Review of Financial Studies, Forthcoming. Available at SSRN: https://ssrn.com/abstract=385500

Vikas Agarwal (Contact Author)

Georgia State University ( email )

35 Broad Street,
Suite 1221
Atlanta, GA 30303-3083
United States
404-413-7326 (Phone)
404-413-7312 (Fax)

HOME PAGE: http://www.gsu.edu/~fncvaa

University of Cologne - Centre for Financial Research (CFR)

Albertus-Magnus Platz
Cologne, 50923
Germany

Narayan Y. Naik

London Business School - Institute of Finance and Accounting ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom
+44 20 7262 5050 (Phone)
+44 20 724 3317 (Fax)

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