The response of hedge fund tail risk to macroeconomic shocks: A nonlinear VAR approach

We study how downside risk taken by hedge fund strategies responds to macroeconomic and financial shocks. Using new empirical measures of systematic tail risk, we find that the impulse response functions of strategies’ multi-moment risk display an asymmetric behavior, being much more significant and nonlinear during the subprime crisis than during the recent expansion period. Our results indicate that managers of hedge fund strategies seek to monitor their tail risk during crises, in the sense that their portfolios seem to behave as puts, which are kurtosis reducers in times of turmoil. However, while some strategies (e.g., futures) succeed quite well in controlling their tail risk during crises, others (e.g., equity market neutral) have difficulties to do so. This is an important result for institutional investors who think that hedge funds are “hedged” and thus immunized against adverse macroeconomic shocks—especially market volatility shocks.