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

See all articles by Laurent Cavenaile

Laurent Cavenaile

University of Toronto at Scarborough; University of Toronto - Rotman School of Management

Alain Coen

Université du Québec à Montréal (UQÀM) - Graduate School of Business (ESG)

Georges Hübner

HEC Liège

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

Cavenaile, Laurent and Coen, Alain and Hübner, Georges, The Impact of Illiquidity and Higher Moments of Hedge Fund Returns on Their Risk-Adjusted Performance and Diversification Potential (October 30, 2009). Journal of Alternative Investments, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1502698

Laurent Cavenaile (Contact Author)

University of Toronto at Scarborough ( email )

1265 Military Trail
Scarborough, Ontario M1C 1A4
Canada

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

Alain Coen

Université du Québec à Montréal (UQÀM) - Graduate School of Business (ESG) ( email )

P.O. Box 8888, Downtown Station
Succursale Centre Ville
Montreal, Quebec H3C 3P8
Canada
514-987-3000 (Phone)
418-681-2501 (Fax)

Georges Hübner

HEC Liège ( email )

Rue Louvrex 14, Bldg. N1
Liege, 4000
Belgium
+32 42327428 (Phone)

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