Buy-Side Risk Management: Hedging Hedge
Fund Outflows

Abstract

In an ideal world, hedging the risk of fund outflows would simply involve the purchase of state-dependent securities that pay a nominal amount if outflows occur and nothing in other states of the world. However, securities of this type are not contractable, given that fund outflows might be performance related or otherwise self-induced. Alternatively, the risk of fund outflows can be (imperfectly) hedged with out-of-the-money digital calls, which pay off one monetary unit if volatility (represented by the VIX) increases by more than a pre-specified amount. The rationale is that strongly increasing risk often leads to both deteriorating hedge fund performance as well as increased client risk aversion. Both factors are likely to trigger hedge fund redemptions, are outside the manager’s control, and represent an exogenous event.The article develops a model to derive the optimal hedging demand and applies it to aggregated hedge fund data.