Dynamic Investment Opportunities and the Cross-Section of Hedge Fund Returns: Implications of Higher-Moment Risks for Performance

This paper examines higher-moment market risks in the cross-section of hedge fund returns to make several contributions. First, it is shown that hedge funds, but not mutual funds, are substantially exposed to volatility, skewness, and kurtosis risks. We find significant cross-sectional variation in the intensity of higher-moment exposures across hedge fund styles and across hedge funds within a particular style, suggesting potential for neutralizing higher-moment risks. Corroborating this result, when funds of hedge funds are investigated as a separate investment category they 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 higher-moment factors to benchmark models can better explain the behavior of hedge fund returns. Bearing on issues of practical consequence, benchmark models augmented with higher-moment factors can considerably alter the hedge funds’ alpha-based rankings.