Failure Risk and the Cross-Section of Hedge Fund Returns

Abstract

Modeling a hedge fund’s probability of failure by a dynamic logit regression, I document that a probability of fund failure has a significantly negative effect on the fund’s future returns. A quintile portfolio with highest failure probability underperforms a quintile portfolio with lowest failure probability by 5~6% per year from 1997 to 2012. The results are robust to the definition of hedge fund failure and controlling for a large set of risk factors and fund characteristics. Moreover, the negative effect of failure probability on future fund returns is stronger for funds with weak share restrictions.