Thursday, May 03, 2007

NY Fed on Hedge Fund Risk

I won't pretend to fully understand an article published May 2 by the Federal Reserve Bank of New York economis Tobias Adrian. It seems to say correlation among hedge funds has increased, but it's increasing covariance we should worry about.

Here's the article.

Here's a few copy-and-pasted paragraphs:

“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. For example, many funds had to close out positions during the LTCM crisis to meet margin calls and satisfy risk management constraints. ...

“One standard measure of the comovement of hedge fund returns is covariance. The covariance across a group of funds essentially captures the extent to which their returns move together (or apart, in the case of negative covariance) in dollar terms. A high covariance between two funds means that when one earns a larger-than-normal amount of money, the other is likely to do the same. However, it matters little if two funds tend to gain or lose at the same time if such joint gains and losses are only a small fraction of the funds’ total returns. Therefore, analysts “normalize” this measure by dividing the covariance of fund returns by the returns’ total variability. This calculation tells us how closely hedge fund returns move together relative to their overall volatility—a different measure of comovement known as correlation. While this measure is frequently used, it has a notable drawback: correlation may change because its numerator (the returns’ covariance) or its denominator (the returns’ volatility) changes. For instance, the correlation of different funds’ returns may rise either because the returns have moved more closely together (their covariance has increased) or because their volatility has fallen. ...

“Complementing this result is our finding that high correlations of returns generally do not precede increases in volatility in the hedge fund sector, but high covariances among hedge funds do. While the LTCM collapse was preceded by high correlations and high covariances in an environment of increased hedge fund return volatility, the current environment is characterized by only average levels of covariances and low volatility. Therefore, with respect to both volatility and covariance, the current environment differs markedly from the one in the months preceding the LTCM crisis.”