Abnormal return patterns and hedge fund failures

Abstract

One reason why quantitative performance and risk measures fail to adequately expose certain risks in hedge funds is the uniqueness of hedge fund strategies and related operational issues in executing these strategies. This paper will first examine the risk exposures and performance characteristics of a sample of live and dead hedge funds, before turning its attention to four recent hedge fund failures. All four of these funds were subject to enforcement proceedings by the Securities and Exchange Commission and/or Commodity Futures Trading Commission. The paper will explore return characteristics of these funds to determine if risk exposures may be used to identify failing funds. The paper shows that a ‘monitoring test’ could be used to determine if a hedge fund manager has significantly changed trading strategy, which may be a signal that the manager is engaged in trading activities not covered by the fund’s investment mandate. The results indicate that careful qualitative and quantitative due diligence could have uncovered some abnormal return patterns in the four failed funds. The paper concludes that both qualitative and quantitative due diligence are equally important in successfully monitoring hedge fund risk exposures.