Is Risk-Neutral Skewness an Indicator of Downside Risk? Evidence from Tail Risk Taking of Hedge Funds

Research suggests that systematic tail risk affects the cross-sectional variation in hedge fund returns. High tail risk hedge funds are known to be exposed to higher-moment risks; they sell market volatility risk and buy market skewness risk. The relationship between a tail risk strategy and a market skewness factor is expected to be positive, but I find it to be negative. Using equity-oriented hedge fund return data, I find that equity market skewness risk explains a major part of variation in hedge funds' tail risk. My results suggest that the observed negative relationship relates to the problem of price pressure associated with "crowded trades" of mutual funds. In particular, in times when investors shift their funds from bond to equity mutual funds, short selling in the index options market induces a negative relationship between risk-neutral market skewness and returns. Accordingly, the long leg of the tail risk strategy appears to be negatively exposed to market skewness risk, which is in contrast to the usual interpretation of option-implied skewness as an indicator of downside risk.