The effects of drawdown risk reduction on the US hedge funds

Abstract

We investigate the effects of drawdown risk reduction on the US hedge funds. Despite the existence of numerous evidences on the asymmetric distribution of portfolio returns, the asymmetric risk measures have been extensively applied in risk management during recent years with the considerable applications on the lower partial moment (LPM) methodology. Unlike prior literatures, we use the drawdown risk measure (DRM), which is a special case of LPM, to study the impacts of drawdown risk decrease on management styles of the US hedge funds. The monthly returns are applied for 1720 US hedge funds over the period 2000-2011. The optimization models in the DRM form are run to optimize the risk measures and investigate the effects of drawdown risk reduction. We find that the potential benefits of funds' diversification may weaken decreases in tolerance levels of drawdown risk. Our findings increase the importance of risk (tolerance) perception, in particular drawdown risk, when making many investment decisions. We find that it can negatively affect portfolio returns. Our findings also show that skewness does not impose any significant problem in the DRM model. The DRM optimization model reduces investors' risk more than the conventional models and can be accommodated with risk-averse investors' approach. © 2013 Macmillan Publishers Ltd.