Caught by the Tail: Tail Risk Neutrality and Hedge Fund Returns

Stephen J. Brown, Jonathan F. Spitzer
2006 Social Science Research Network  
We propose a simple and yet robust measure of tail neutrality. By this measure, hedge funds are more sensitive to market risk when the market experiences a substantial decline. This is also true when we consider a number of distinct hedge fund styles. This source of risk is not diversifiable, and for this reason funds-of-funds as portfolios of hedge funds concentrate tail risk exposure rather than mitigate this effect. In today's uncertain market environment, the idea of investing in a fund
more » ... sting in a fund immune from the day-to-day fluctuations in the market has a certain attraction. Indeed most hedge funds strategies generate returns that are reasonably uncorrelated with standard benchmarks. This leads many investors to believe that they are actually less risky than their active trading strategies would suggest. For many hedge funds this low correlation is illusory. Many active trading strategies that anticipate market movements will enter and leave the market with some frequency generating returns that are uncorrelated with benchmarks over the extended holding period of the average hedge fund investor. But this does not imply that they are low risk strategies, as in the kind of liquidity crisis that could prove fatal to the success of these trading schemes would cause the funds to fail just as the market is collapsing. This is of concern not only to investors but also to regulators as well. The bailout of LTCM in 1998 was occasioned by fears among regulators that liquidity problems at this fund could have a contagion effect spreading across the
doi:10.2139/ssrn.1852526 fatcat:ggaufzozabcqfcysffsifnis5q