Extreme Macroeconomic Events and Hedge Fund Performance: Identifying Hidden Risks in Quantitative Long/Short Equity and Risk Arbitrage

Abstract

This paper considers hidden risks present within the hedge fund industry by focusing on two particular investment strategies. Quantitative long/short equity funds presented a new and interesting opportunity for risk assessment when many experienced massive losses over three days in August 2007. Following the approach of Khandani and Lo (2007), I employ a “contrarian” trading model to replicate these returns and to better understand systematic risk within the strategy. In addition to a successful “robustness check” on Khandani and Lo’s finding that the losses were most likely a result of the deleveraging of one or more large equity portfolios, I empirically justify a theory that contrarian returns are negatively related to market volatility, offer a new approach to estimating and analyzing leverage, and present a qualitative discussion of the hidden risks associated with portfolio overlap. Risk arbitrage, the second hedge fund strategy, is known to exhibit a non-linear and option-like risk and return profile. Utilizing the piecewise linear estimation model of Mitchell and Pulvino (2001), I find that returns of a particular merger arbitrage mutual fund and hedge fund index exhibit strong market correlation during down markets and little or no relationship during appreciating markets. Since this closely resembles a short position in an index put option, I adjust risk using a Black-Scholes replicating portfolio to find annual excess returns generated by risk arbitrage of about 4.5%. These conclusions, although useful in this context, cover just two hedge fund strategies. The intent is to emphasize the importance of alternative methods of risk assessment and to encourage further research into the topic of hidden risk.

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