Tail Risks Across Investment Funds

Jerchern Lin

doi:10.18778/2391-6478.S1.2024.05

Authors

Jerchern Lin University of Illinois at Chicago https://orcid.org/0000-0002-2281-7068

DOI:

https://doi.org/10.18778/2391-6478.S1.2024.05

Keywords:

Tail Risk, Systematic Risk, Idiosyncratic Risk, Coskewness, Cokurtosis, Copula, Tail Dependence, ETFs, Closed-end Funds, Mutual Funds, Hedge Funds, Compensation

Abstract

The purpose of the article. Managed portfolios are subject to tail risks, which can be either index level (systematic) or fund-specific. Examples of fund-specific extreme events include those due to big bets or fraud. This paper studies the two components in relation to compensation structure in managed portfolios.

Methodology. A novel methodology is developed to decompose return skewness and kurtosis into various systematic and idiosyncratic components and applied it to the returns of different fund types to assess the significance of these sources. In addition, a simple model generates fund-specific tail risk and its asymmetric dependence on the market, and makes predictions for where such risks should be concentrated. The model predicts that systematic tail risks increase with an increased weight on systematic returns in compensation and idiosyncratic tail risks increase with the degree of convexity in contracts.

Results of the research. The model predictions are supported with empirical results. Hedge funds are subject to higher idiosyncratic tail risks and Exchange Traded Funds exhibit higher systematic tail risks. In skewness and kurtosis decompositions, the results indicate that coskewness is an important source for fund skewness, but fund kurtosis is driven by cokurtosis, as well as volatility comovement and residual kurtosis, with the importance of these components varying across fund types. Investors are subject to different sources of skewness and fat tail risks through delegated investments. Volatility based tail risk hedging is not effective for all fund styles and types.

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