INVESTIGATING THE FINANCIAL DISTRESS RISK PUZZLE WITHIN THE HEDGE FUND INDUSTRY

This study investigates the conventional wisdom that financial assets with higher risk levels should yield higher returns, a concept known as the risk-return trade-off. However, empirical research indicates that financially distressed assets tend to yield lower returns. Although several potential explanations have been proposed, there remains a lack of consensus in the literature regarding the underlying causes. Motivated by this puzzle, this study aims to ascertain whether distress risk is present in the hedge fund industry. To this end, this study empirically analyzes hedge funds monthly returns over a fourteen-year period from January 2000 to August 2016 and research is based upon a sample of 7151 hedge funds. The data were further segmented to capture both bull and bear market conditions and various hedge fund strategies. The results demonstrate that the distress risk puzzle is evident in the hedge fund industry. The findings suggest that hedge funds with a high probability of default do not yield higher returns, whereas those with a low probability of default yield higher returns. This study indicates that hedge funds with a high probability of default are riskier, and investors are not adequately compensated for investing in these funds.