Predicting Hedge Fund Failure: A Comparison of Risk Measures

Abstract

This paper compares downside risk measures that incorporate higher return moments with traditional risk measures such as standard deviation in predicting hedge fund failure. When controlling for investment strategies, performance, fund age, size, lockup, high-water mark, and leverage, we find that funds with larger downside risk have a higher hazard rate. However, standard deviation loses the explanatory power once the other explanatory variables are included in the hazard model. Further, we find that liquidation does not necessarily mean failure in the hedge fund industry. By reexamining the attrition rate, we show that the real failure rate of 3.1% is lower than the attrition rate of 8.7% on an annual basis during the period of 1995–2004.