Dynamic Investment Opportunities and the Cross-Section of Hedge Fund Returns : Implications of Higher-Moment Risks for Performance

• Main Authors: AGARWAL, Vikas, BAKSHI, Gurdip, HUIJ, Joop
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2008
• Subjects: Volatility Risk; Skewness Risk; Kurtosis Risk; Higher Moments; Exposures; Hedge Funds; Alphas; Portfolio and Security Analysis
• Online Access: https://ink.library.smu.edu.sg/bnp_research/5; https://ink.library.smu.edu.sg/cgi/viewcontent.cgi?article=1006&context=bnp_research
• Institution: Singapore Management University

In this paper, we examine higher-moment market risks in the cross-section of hedge fund returns to make several contributions. First, we show that hedge funds are substantially exposed to the three highermoment risks - volatility, skewness, and kurtosis. In contrast, mutual funds do not display meaningful dispersions in their exposures to these risks. Further, funds of hedge funds when examined as a separate investment category do not show aggressive loading on higher-moment risks. Second, we provide evidence on economically significant premiums being embedded in hedge fund returns on account of their exposures to higher-moment risks. Third, we uncover a set of higher-moment factors that are not strongly associated with factors in benchmark models that are currently used for evaluating hedge fund performance. Finally, the addition of these higher-moment factors to benchmark models can better explain the variation in hedge fund returns. Bearing on issues of practical consequence, we find that benchmark models augmented with higher-moment factors can considerably alter the hedge funds’ alpha-based rankings.