Daily Academic Alpha: Higher Moments in Hedge Funds

Daily Academic Alpha: Higher Moments in Hedge Funds

March 23, 2015 Momentum Investing Research, Uncategorized

Last updated on January 18th, 2017 at 02:20 pm

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Higher‐Moment Risk Exposures in Hedge Funds

This paper singles out the key roles of US equity skewness and kurtosis in the hedge fund return generating process. We propose a conditional higher‐moment model with location, trading, and higher‐moment factors to describe the dynamics of the equity hedge, event‐driven, relative value, and fund of funds styles. If the volatility, skewness, and kurtosis implied in US options are used by fund managers as instruments to anticipate market movements, managers should adjust their market exposure in response to variations in these moments. We indeed show that higher‐moment premia improve the conditional asset pricing model across all hedge fund styles.

Volatility of Aggregate Volatility and Hedge Fund Returns

This paper investigates empirically whether uncertainty about the expected returns on the market portfolio can explain the performance of hedge funds both in the cross-section and over time. We measure uncertainty via volatility of aggregate volatility (VOV) and construct an investable version of this measure by computing monthly returns on lookback straddles written on the VIX index. We find that VOV exposure is a significant determinant of hedge fund returns at the overall index level, at different strategy levels, and at an individual fund level. We find that funds with low (more negative) VOV betas outperform funds with high VOV betas by 1.62% per month. After controlling for a large set of fund characteristics, we document a robust and significant negative risk premium for VOV exposure in the cross-section of hedge fund returns. We further show that strategies with less negative VOV betas outperform their counterparts during the financial crisis period when uncertainty about expected returns was at its highest. On the contrary, strategies with more negative VOV betas generate superior returns when uncertainty in the market is less. Furthermore, the variation in the VOV betas is consistent with the risk-taking incentives of hedge funds arising from the different fund characteristics including their contractual features.

How Risky are Low-Risk Hedge Funds?

This paper investigates the determinants of the average level of risk of hedge funds, which provide high liquidity to their investors and report their returns on a daily basis. We find that larger funds and funds charging higher incentive fees exhibit lower risk, whereas funds charging higher management fees, imposing longer notice periods, and stemming from large fund-families take more risk. There is considerable variation in the risk levels between funds reporting in Euro and USD, with Euro funds being consistently less risky, suggesting that these funds target different types of investors with other preferences.

 


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About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.