The New York Federal Reserve has issued a warning that hedge funds could be posing the greatest risks to the markets since the crisis of Long-Term Capital Management in 1998.
In a paper, “Measuring Risk in the Hedge Fund Sector”, in this week’s edition of “Current Issues in Economics and Finance” published Wednesday, Tobias Adrian, an economist in the Capital Markets Function of the Research and Statistics Group at the NY Fed, states that recent high correlations among hedge fund returns could suggest concentrations of risk comparable to those preceding the hedge fund crisis of 1998 which resulted in fund returns all moving in the same direction. This crisis resulted in a $3.6 billion lifeboat, organized by the NY Fed and funded by Wall Street banks. The cost of another such bail-out will be concerning the authorities and there is concern whether the major banks would be as cooperative as the last time.
To determine how closely hedge fund returns move together relative to their overall volatility, economists divide the covariance of fund returns, the measurement of hedge fund returns’ common movement, by the returns’ total variability; the result is correlation—returns moving in the same direction when facing similar market conditions.
Adrian proposes that the recent high correlations among hedge fund returns could suggest concentrations of risk comparable to those preceding the hedge fund crisis of 1998. However, he does identify a key difference: the recent increase in correlation may be caused principally by the decline in the volatility of returns, while the 1998 rise was driven by the then high covariances.
The paper says, "While the funds are major liquidity providers in normal times, their use of leveraged trading strategies has raised concerns about their liquidity effects in times of market stress. Indeed, the collapse of 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."
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