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Trapped in diversification – another look at the risk of fund of hedge funds

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  • Wei Cui
  • Juan Yao
  • Stephen Satchell

Abstract

Recent literature implies that despite being more diversified, fund of hedge funds (FOFs) are exposed to tail risk. We propose an explanation for this phenomenon; tail risk is a systematic risk factor for hedge funds, which by construction, explains the higher portion of the returns in the diversified portfolios. Our study suggests that not only an additional tail risk factor improves the explanatory power of the factor model, the relative importance of tail risk factor increases with the number of underlying hedge funds in an FOF portfolio. Furthermore, we demonstrate that FOFs with a short history, higher management fees, leverage and requiring shorter lockup periods are more sensitive to tail risk.

Suggested Citation

  • Wei Cui & Juan Yao & Stephen Satchell, 2019. "Trapped in diversification – another look at the risk of fund of hedge funds," The European Journal of Finance, Taylor & Francis Journals, vol. 25(12), pages 1055-1076, August.
    • Handle: RePEc:taf:eurjfi:v:25:y:2019:i:12:p:1055-1076
    DOI: 10.1080/1351847X.2019.1571524
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    Cited by:

    1. Cui, Wei & Yao, Juan, 2020. "Funds of hedge funds: Are they really the high society for little guys?," International Review of Economics & Finance, Elsevier, vol. 67(C), pages 346-361.
    2. Sarwar, Ghulam, 2022. "Market risks that change domestic diversification benefits," The North American Journal of Economics and Finance, Elsevier, vol. 63(C).

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