Risk and Return in Hedge Funds and Funds-of-Hedge Funds: A Cross-Sectional Approach
Lee, Hee Soo, Australasian Accounting Business & Finance Journal
The objective of this study is to examine whether the available data on individual hedge funds (HFs) and funds-of-hedge funds (FOHFs) can reveal the risk-return trade-offand, if so, to find an appropriate risk measure that captures the cross-sectional variation in HF and FOHF returns and compare the risk-return relationship in HFs and FOHFs. Using the "live funds" and the "dead funds" datasets provided by Hedge Fund Research Inc. (HFR), we concentrate on alternative risk measures such as semi-deviation, VaR, expected shortfall and tail risk and compare them with standard deviation in terms of their ability to describe the cross-sectional variation in expected returns of HFs and FOHFs. Firstly, the risk measures are analysed at the portfolio level of HFs and FOHFs by adopting the Fama and French (1992) approach. Secondly, the various estimated risk measures are compared at the individual HF and FOHF levels by using univariate and multivariate cross-sectional regressions. The results show that the available data on HFs and FOHFs exhibits different risk-return trade-offs. The Cornish-Fisher expected shortfall or Cornish-Fisher tail risk could be an appropriate risk measure for HF return. Although appropriate alternative risk measures for the HFs are found, it is difficult to determine the risk measures that best capture the cross-sectional variation in FOHF returns.
Keywords Hedge funds; funds-of-hedge funds; VaR; expected shortfall; tail risk
JEL Codes: G32
(ProQuest: ... denotes formulae omitted.)
The hedge fund industry has grown significantly over the past 60 years. Extended from US based investments to Europe, Asia and Australia, the hedge fund industry expanded dramatically during the period of 1980s through to early 2000s. The rapid growth of hedge fund industry was achieved through increased number of new financial instruments and improved technology, which helped to develop sophisticated investment strategies, during the same periods. In addition, the performance based incentive fee structure has attracted high- skilled professionals to invest in hedge funds. Both assets under management (AUM) in hedge funds and the number of funds increased from around US$39 billion with 610 funds in 1990 to US$1,900 billion with 9,237 funds in 2010 (HFR 2010). Following a decade of notable growth, assets under management (AUM) of the hedge fund industry decreased remarkably in 2008 due to the Global Financial Crisis (GFC). The International Financial Services London (IFSL) estimated that AUM would decline by more than 20% to US$1,500 billion in 2008. Being the biggest on record, the decrease was caused by the combination of negative performance, rush in redemptions and liquidations of fund (IFSL 2009).
Traditional investment strategies adopted by institutional investors had failed to satisfy their objectives in terms of return and risk, which had led investors to seek new ways of diversification. Many high-net-worth individuals, as well as institutional investors, have shown growing interest in hedge funds. With fund-of-hedge funds (FOHFs) being vehicles that provide combined investments in individual hedge funds (HFs), investment in them has been open to a wide range of investors. On the other hand, only institutions and high-networth individuals are allowed to invest in HFs. A large part of growth in the hedge fund industry was due to an increase in the number of FOHFs. The HFR Industry Report in 2010 reported that most investors have increasingly adopted FOHFs as the preferred investment vehicles and they were estimated to account for 20% to 25% of global hedge fund industry assets at the end of 2009.
FOHFs became more favoured by various investors given that FOHFs usually demand less initial investment than the HFs. As the name indicates, FOHFs invest in a number of HFs for the purpose of diversifying fund risk. This allows investors to allocate assets in dynamic market conditions. …