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.
Volatility Risk, Skewness Risk, Kurtosis Risk, Higher Moments, Exposures, Hedge Funds, Alphas
Portfolio and Security Analysis
Singapore Management University, BNP Paribas Hedge Fund Centre
Agarwal, Vikas; Bakshi, Gurdip; and Huij, Joop.
(2008). Research Collection BNP Paribas Hedge Fund Centre.
Available at: http://ink.library.smu.edu.sg/bnp_research/5