(June 28, 2012) -- Investors must better distinguish between skill of hedge fund managers and their propensity to take on extra risk, according to Bryan Kelly, a professor of the University of Chicago.
"We want to distinguish between genuine expertise of a hedge fund manager rather than outperforming by taking on extra risk -- anyone can take on extra crash risk and get a higher return," Kelly told aiCIO following the recent release of his academic paper on the topic, which he co-wrote with Erasmus University Professor Hao Jiang.
If investors want to measure risk correctly, they must be more careful about calculating the returns generated by hedge fund managers' willingness to take tail-risk positions, exposing them to downside risk, according to Kelly's paper titled "Tail Risk and Hedge Fund Returns." The main thrust of the research: hedge fund managers tend to be more willing to take on positions that have a high likelihood of crashing in order to earn higher expected returns.
"A common analogy made is to think about earthquake insurance," Kelly said. "If you're a writer of earthquake insurance, you will have nice, stable returns. Most of the time you don't pay out anything -- it's like free money. But when an earthquake hits losses are huge. Hedge fund investing is also a tail risky strategy that loads up on potential for crashes."
What's the solution then to a more accurate portrayal of hedge fund manager alpha?
According to Kelly, the answer lies in the use of a benchmark that takes on more highly risky investments. "We also propose a benchmark that invests in stocks that have a higher likelihood of crashes," Kelly asserted.
The paper states: "We have shown that hedge funds exhibit persistent exposures to extreme downside risk. For instance, the very same hedge funds that underperformed in the 1998 crisis suffered predictably lower returns during the 2007-2008 crisis…we find that tail risk is an important determinant of the time-series and cross-section variation of hedge fund returns."
The paper continued to note that the results described in the paper "are consistent with the notion that a significant component of hedge fund returns can be viewed as compensation for providing insurance against tail risk."
Read the full paper here.