Andrea Buraschi
Imperial College Business School; Centre for Economic Policy Research (CEPR)
Robert Kosowski
Imperial College Business School
Fabio Trojani
Swiss Finance Institute; University of Lugano
Abstract
This paper analyzes the relation between correlation risk and the cross-section of hedge fund returns. Legal framework and investment mandate imply that hedge funds can be severely exposed to correlation risk: Hedge funds' ability to enter long-short positions can be useful to reduce market beta, but it can severely expose the fund to unexpected changes in correlations. Our empirical study produces the following novel ?findings to the literature. First, hedge funds' absolute returns are explained to a statistically and economically signi?ficant percentage by exposure to correlation risk. Second, different exposures to correlation risk explain cross-sectional differences in hedge fund excess returns. Third, correlation risk is the only priced risk factor in the cross-section of hedge fund returns. At the same time, other risk factors, like the market return, are not priced. Fourth, exposure to correlation risk is linked to an asymmetric risk pro?file: Funds selling protection against correlation increases have maximum drawdowns much higher than funds buying protection against correlation risk. Fifth, failure to account for correlation risk exposures leads to a strongly biased estimation of funds' risk-adjusted performance. These ?findings have implications for hedge fund risk management, the categorization of hedge funds according to their risk pro?file and recent legislation that allows mutual funds to follow so-called 130/30 long-short strategies.
H/T CXO Advisory Group, where they comment on this paper in this article.
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