This paper examines the tail risk in hedge funds through their exposure to downside crash risk in equity markets. Using data on hedge fund returns, we find that crash risk exposure predicts the returns of hedge funds. Furthermore, using data on hedge funds’ long equity positions as revealed in their mandatorily disclosed quarterly holdings, we find that crash risk of equity holdings on average explains more than 30% of hedge funds’ overall crash risk. This relationship holds even after controlling for different stock characteristics and is not explained by hedge funds’ exposure to an out-of-the-money put option factor as in Agarwal and Naik (2004) and factors that proxy for dynamic trading strategies as in Fung and Hsieh (2001).
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