Is There Hedge Fund Contagion?

We examine whether hedge funds experience contagion. First, we consider whether extreme movements in equity, fixed income, and currency markets are contagious to hedge funds. Second, we investigate whether extreme adverse returns in one hedge fund style are contagious to other hedge fund styles. To conduct this examination, we estimate binomial and multinomial logit models of contagion using daily returns on hedge fund style indices as well as monthly returns on indices with a longer history. Our main finding is that there is no evidence of contagion from equity, fixed income, and foreign exchange markets to hedge funds, except for weak evidence of contagion for one single daily hedge fund style index. By contrast, we find strong evidence of contagion across hedge fund styles, so that hedge fund styles tend to have poor coincident returns.

Hedge Fund Contagion and Liquidity

Using hedge fund indices representing eight different styles, we find strong evidence of contagion within the hedge fund sector: controlling 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. We investigate how changes in funding and asset liquidity intensify this contagion, and find that 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. Finally, we examine whether extreme poor performance in the stock, bond, and currency markets is more likely when contagion in the hedge fund sector is high. We find no evidence that contagion in the hedge fund sector is associated with extreme poor performance in the stock and bond markets, but find significant evidence that performance in the currency market is worse when hedge fund contagion is high, consistent with the effects of an unwinding of carry trades.

Do ETFs increase the commonality in liquidity of underlying stocks?

We examine the impact of ETF ownership on the commonality in liquidity of underlying stocks, while controlling for other institutional ownership. Analyses using aggregate stock-level ETF ownership and common ETF ownership at the stock-pair level indicate that ETF ownership significantly increases commonality. We show that greater arbitrage activities are associated with a larger effect of ETF ownership on commonality. We use quasi-natural experiments that exploit the reconstitution of Russell indexes, and ETF trading halts, to establish the causal effect of ETF ownership and the arbitrage mechanism, respectively. Our results suggest that ETFs reduce investors' ability to diversify liquidity risk

Liquidity Shocks and Hedge Fund Contagion

In Boyson, Stahel, and Stulz (2010), we investigate whether hedge funds experience worst return contagion-- that is, correlations in extremely poor returns that are over and above those expected from economic fundamentals. We find strong evidence of contagion among hedge funds using eight separate style indices for the period from January 1990 to October 2008: the probability of a worst return in a particular index is increasing in the number of other indices that also have extremely poor returns. We then show that large adverse shocks to asset and funding liquidity strongly increase the likelihood of this contagion. In this paper, we further investigate contagion between hedge funds and main markets. We uncover strong evidence of contagion between hedge funds and small-cap, mid-cap and emerging market equity indices, high yield bonds, emerging market bonds, and the Australian Dollar. Finally, we show that this contagion between hedge funds and markets is also significantly linked to liquidity shocks, especially for small-cap domestic equities, Asian equities, high yield bonds, and the Australian Dollar.

Is There Hedge Fund Contagion?

We examine whether hedge funds experience contagion. First, we consider whether extreme movements in equity, fixed income, and currency markets are contagious to hedge funds. Second, we investigate whether extreme adverse returns in one hedge fund style are contagious to other hedge fund styles. To conduct this examination, we estimate binomial and multinomial logit models of contagion using daily returns on hedge fund style indices as well as monthly returns on indices with a longer history. Our main finding is that there is no evidence of contagion from equity, fixed income, and foreign exchange markets to hedge funds, except for weak evidence of contagion for one single daily hedge fund style index. By contrast, we find strong evidence of contagion across hedge fund styles, so that hedge fund styles tend to have poor coincident returns.