Tail Risk in Funds of Hedge Funds

Abstract

Funds of hedge funds (FOFs) are portfolios of investment in hedge funds. Marketed to retail investors who are otherwise unable to access hedge fund investments, FOFs are normally depicted as well-diversified investment vehicles that benefit investors with their due-diligence selection process. However, some earlier research has suggested that FOFs work like disaster insurance writers (Stulz, 2007; Agarwal and Naik, 2004). The implication is that they gain stable premium income during normal times but lose dramatically when the insured event occurs. The primary objective of this dissertation is to study the tail risk exposures of FOFs. Compared with hedge funds, which are exposed to tail risk mainly through dynamic trading, large leverage, and holdings of tail-risk-sensitive or illiquid assets (Agarwal et al., 2015), FOFs are obviously exposed to tail risk for different reasons. After conducting a hedge fund tail risk measurement (HFTR), I found that HFTR significantly explains the returns of FOFs. Moreover, HFTR substantially enhances the adjusted R-square of Fung and Hsieh’s (2004a) seven-factor model. Despite FOFs being ostensibly more diversified portfolios, they have even higher exposure to tail risk compared to hedge funds. Moreover, FOFs with short histories, higher management fees and leverage, and shorter lockup periods are more sensitive to tail risk. I further documented a strong return-predictive power in FOFs’ tail risk exposures. In particular, I found that the possible losses to one unit of tail risk exposure in a bearish market are double the possible gains in a bullish market. This non-linear payoff structure is a testimony to the claim that FOFs write crash insurance for hedge funds.