Distress risk puzzle : a hedge fund industry analysis

Abstract

Conventional wisdom suggests that financial assets with higher level of risk should have a higher level of return. This is referred to as the risk-return tradeoff. However, empirical studies conclude that financially distressed financial assets have lower returns. While a few potential explanations have been proposed, there is still no consensus in the literature as to what drives this anomaly. Motivated by the puzzle, this dissertation seeks to determine if presence of distress risk in the hedge fund industry can be found. Accordingly, in order to achieve the above, this dissertation empirically analyses the monthly returns of hedge funds, over a fourteen (14) year period from January 2000 until August 2016. The data was further split to also capture both bull and bear market conditions as well as different hedge fund strategies. Results presented show that the distress risk puzzle is also present in the hedge fund industry. Findings suggests that hedge funds with high probability of default do not deliver higher returns whilst hedge funds with low probability of default do. This research has shown that high probability of default hedge funds are riskier and investors are not being compensated enough for investing in these funds.