When is poor hedge fund performance contagious?

I uploaded a new paper with Nicole Boyson and Christof Stahel titled “Hedge fund contagion and liquidity”. In this paper, we investigate when different hedge fund styles perform poorly at the same time and whether poor performance across hedge fund styles is accompanied by poor performance in the broad markets.

Our empirical work uses returns on eight HFR hedge fund styles from 1990 to the end of 2007. Using these returns, we focus on returns in the 10% lower tail of the distribution. We find strong evidence of contagion in the hedge fund industry in the following sense. Controlling for known determinants of hedge fund style returns, we find that the number of styles with returns in the 10% lower tail of their distribution strongly affects the probability that a style will have a return in the 10% lower tail of its distribution (an extreme poor return). On average, the probability that a style has an extreme poor return increases from 1.8% to 20.9% as the number of other styles with extreme poor returns increases from 1 to 8.

We investigate hedge fund contagion channels. We hypothesize that hedge fund contagion should be stronger when prime brokers are financially weak, because this reduces credit to hedge funds, and when liquidity in securities markets is poor, as this makes it costly for hedge funds to delever. We find strong support for this hypothesis. When prime brokers have extreme poor returns and when the stock market has extreme poor liquidity, the number of hedge fund styles with extreme poor returns is 4.33. Otherwise, only 0.70 hedge fund styles have extreme poor returns.

Strikingly, the dollar performs more poorly when the number of hedge fund styles with extreme poor returns is high. We attribute this relation to the carry-trade. We find no evidence that the number of hedge fund styles with extreme poor returns is related to the performance of the stock market or of the bond market.

One Response to "When is poor hedge fund performance contagious?"

  1. Anonymous   January 13, 2009 at 6:06 pm

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