The Impact of Illiquidity and Higher Moments of Hedge Fund Returns on Their Risk-Adjusted Performance and Diversification Potential
Posted: 17 Nov 2009 Last revised: 19 Feb 2011
Date Written: October 30, 2009
Abstract
This paper studies the joint impact of smoothing and fat tails on the risk-return properties of hedge fund strategies. First, we adjust risk and performance measures for illiquidity and the non-Gaussian distribution of hedge funds returns. We use two risk metrics: the Modified Value-at-Risk and a preference-based measure retrieved from the linear-exponential utility function. Second, we revisit the hedge fund diversification effect with these adjustments for illiquidity. Our results report similar fund performance rankings and optimal hedge fund strategy allocations for both adjusted metrics. We also show that the benefits of hedge funds in portfolio diversification are still persistent but tend to weaken after the adjustment for illiquidity.
Keywords: Illiquidity, Non-Gaussian returns, Hedge fund performance, Modified Value-at-Risk, Portfolio diversification
JEL Classification: G12, G15
Suggested Citation: Suggested Citation