Hedge fund contagion and liquidity

Hedge fund contagion and liquidity

The finance and economics literatures often use the term contagion to describe a situation where there is excess correlation, and poor performance spreads across countries, asset classes, or investment strategies for reasons not related to correlations in fundamentals.

There are strong evidence of contagion within the hedge fund sector during periods of stress: quantitative analysis revealed that for a number of risk factors, the average probability that a hedge fund style index has extreme poor performance (lower 10% tail) increases from 2% to 21% as the number of other hedge fund style indices with extreme poor performance increases from zero to seven. Changes in funding and asset liquidity seem are found to intensify this contagion effect, where the likelihood of contagion is high when prime brokerage firms have poor performance (which would be expected to affect hedge fund funding liquidity adversely) and when stock market liquidity (a proxy for asset liquidity) is low. Further, contagion is exacerbated when hedge funds experience large outflows as large investors request for withdrawals force hedge funds to liquidate assets in unfavorable circumstances. Yet there is no evidence that contagion in the hedge fund sector is associated with extreme poor performance in the stock and bond markets, yet currency markets seem to worsen when hedge fund contagion is high, consistent with the effects of an unwinding of carry trades. Therefore, there is evidence that hedge fund contagion is associated with extremely poor performance of the currency markets (which is consistent with an unwinding of carry trades), but not of the stock and bond markets.

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