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Keywords:

  • hedge funds;
  • expected shortfall;
  • tail risk;
  • conditional VaR;
  • Cornish-Fisher expansion
  • G11;
  • G12;
  • C31

Abstract

This paper analyses the risk-return trade-off in the hedge fund industry. We compare semi-deviation, value-at-risk (VaR), Expected Shortfall (ES) and Tail Risk (TR) with standard deviation at the individual fund level as well as the portfolio level. Using theFama and French (1992)methodology and the combined live and defunct hedge fund data from TASS, we find that the left-tail risk captured by Expected Shortfall (ES) and Tail Risk (TR) explains the cross-sectional variation in hedge fund returns very well, while the other risk measures provide statistically insignificant or marginally significant results. During the period between January 1995 and December 2004, hedge funds with high ES outperform those with low ES by an annual return difference of 7%. We provide empirical evidence on the theoretical argument byArtzner et al. (1999)that ES is superior to VaR as a downside risk measure. We also find theCornish-Fisher (1937)expansion is superior to the nonparametric method in estimating ES and TR.