Hedging Equity Market Risk in Hedge Fund Investing: A New Approach

We argue that investors in funds of hedge funds underestimate the traditional equity market beta of these perceived absolute return investment vehicles. Hence, during times of financial crisis, when the correlations of most asset categories with each other increase dramatically, the traditional equity market beta can have an adverse effect on fund of funds performance. Because investors in such environments are rarely able to redeem their fund of fund holdings due to either a general low liquidity (e.g., notice and redemption periods or lock-ups), or extraordinary circumstances (e.g., maximum redemptions, gates, side-pockets), we posit that the only way to decrease unwanted exposure is through overlay strategies. The academic literature so far has focused on the multifactor approach to estimate equity exposure in hedge fund portfolios. We compare different hedging approaches: a pure value-at-risk (VaR)-based approach, a technical market risk signal approach, and a combination of both over the May 2004-September 2009 period using weekly data from an investable hedge fund index. Our results suggest that using a risk overlay system for funds of hedge funds decreases the downside risk of hedge fund investing significantly during economic crises.