Tailing tail risk in the hedge fund industry

Abstract: This paper aims to assess dynamic tail risk exposure in the hedge fund sector using daily data. We use a copula function to model both lower and upper tail dependence between hedge funds, bond, commodity, foreign exchange, and equity markets as a func-tion of market uncertainty, and proxy the latter by means of a single index that combines the options-implied market volatility, the volatility risk premium, and the swap and term spreads. We find substantial time-variation in lower-tail dependence even for hedge-fund styles that exhibit little unconditional tail dependence. This illustrates well the pitfalls of confining attention to unconditional measures of tail risk. In addition, lower-tail depen-dence between hedge fund and equity market returns decreases significantly with market uncertainty. The only styles that feature neither unconditional nor conditional tail depen-dence are convertible arbitrage and equity market neutral. We also fail to observe any tail dependence with bond and currency markets, though we find strong evidence that the lower-tail risk exposure of macro hedge funds to commodity markets increases with liquid-ity risk. In stark contrast, there is not much action in the upper tails. Our results are robust to changes in the specific measure of tail dependence as well as in the factors tha