Risk Profiles of Distressed Hedge Funds

Abstract

This article examines differences in average estimated risk premiums of individual distressed hedge funds as compared to those of their surviving counterparts, along with a unique measure of performance in order to provide evidence of why the distressed funds eventually dissolved. The sample period is selected to cover the sharp downturn in U.S. equity markets of 2000 and beyond, when many individual hedge funds dissolved. Sample data are derived from a unique database of the five major hedge fund providers existing during the sample period. The estimation technique is performed on a sample of 212 distressed hedge funds and 1,555 surviving funds of various investment styles. The main results generally show that for the diverse hedge fund styles the average risk premiums of the distressed funds are greater in absolute value than those of their surviving peers; moreover, these differences generally correspond to significantly lower average performance values for the distressed funds. In short, the hedge funds with the greatest exposure to the risk factors are the funds most at risk of dissolution. These results are of particular importance for individual investors as economic warning signals in monitoring the performance and risk characteristics of the funds comprising their investment portfolios.