Risks and Portfolio Decisions involving Hedge Funds

Hedge funds are known to exhibit nonlinear optionlike exposures to standard asset classes and therefore the traditional linear factor model provides limited help in capturing their riskreturn tradeoffs. We address this problem by augmenting the traditional model with optionbased risk factors. Our results show that a large number of equityoriented hedge fund strategies exhibit payoffs resembling a short position in a put option on the market index, and therefore bear significant lefttail risk, risk that is ignored by the commonly used meanvariance framework. Using a meanconditional ValueatRisk framework, we demonstrate the extent to which the meanvariance framework underestimates the tail risk. Working with the underlying systematic risk factors, we compare the longrun performance with the recent performance of hedge funds and find that their recent performance appears significantly better than their longrun performance. Our analysis provides important insights that can be helpful in addressing issues like construction of fund of funds, risk management, benchmark design and manager compensation involving hedge funds.