A study conducted by the Federal Reserve Bank of NY revealed recent high correlations among hedge fund returns, returns moving in the same direction when facing similar market conditions, which could suggest concentrations of risk comparable to those preceding the Long Term Capital Management hedge fund crisis of 1998. But the comparison of the current rise in correlations with the elevation before the 1998 event reveals a key difference, which is that the recent increase stems mainly from a decline in the volatility of returns, while the earlier rise was driven by high covariances.
Covariance measures hedge fund return comovement by capturing the extent to which the returns move together, or apart, in dollar terms. To determine more precisely how closely hedge fund returns comove relative to their overall volatility, economists divide the covariance of fund returns by the returns’ total variability; the result is correlation.
The Fed study concludes that, despite some seeming parallels between the recent and earlier rise in correlations, the current hedge fund environment differs from the 1998 environment because volatility and covariances now are lower.
In 1998, the Federal Reserve, particularly the NY Fed, facilitated the private-sector refinancing of the large hedge fund, Long-Term Capital Management. The effort was characterized by then NY Fed President William McDonough as a private sector solution to a private-sector problem, involving an investment of new equity by LTCM’s creditors and counterparties.
While hedge funds are major liquidity providers in normal times, the Fed study noted, their use of leveraged trading strategies has raised concerns about their liquidity effects in times of market stress. Indeed, the collapse of the hedge fund LTCM in 1998 seemed to confirm fears that heavy losses by hedge funds have the potential to drain significant liquidity from key financial markets.
These ongoing concerns about hedge fund vulnerability, coupled with the rapid growth of the funds, underscore the importance of understanding risk in this sector. Risk is a critical component of hedge fund strategies, emphasized the study, so the way in which it is measured is extremely important. A key determinant of hedge fund risk is the degree of similarity between the trading strategies of different funds. Similar trading strategies can heighten risk when funds have to close out comparable positions in response to a common shock.