To determine common risk factors that drive performance, the authors explore hedge fund asset allocations, concentration risk, and the associated returns. Exposure to emerging market—rather than developed market—equities provided higher returns during the upmarket period of October 2003–September 2006 and much lower returns during the 2007–09 financial crisis.
The authors’ objective is to measure commonality in hedge fund returns, defined as the extent to which the returns are driven by common factors. They study the Lipper TASS database from January 1994 to June 2009 and measure the commonality in the returns of 12 risk factors, including equity-oriented, trend-following, and bond-oriented factors; various emerging market and developed market return indices; and additional risk factors frequently used in the literature to model hedge funds’ risk exposure.
They also examine the main driving factors of hedge fund returns and determine their effects on the stability of the financial system and on investors. Finally, the authors investigate the risk exposures of hedge funds during an upmarket period and a severe economic downturn to illustrate the hedge fund returns realized in both segments of a business cycle.
How Is This Research Useful to Practitioners?
The target audience for this research includes practitioners working at hedge funds that use a broad range of investment strategies, prime brokers, and private practitioners in the financial sector.
The authors come to several important conclusions. First, from 2004 to the end of 2006, the increase in hedge funds’ exposure to emerging market equities suggests this exposure is the common factor driving hedge fund returns and the main driver of the rise in hedge funds’ commonality in the sample. According to the research, funds with low commonality have little or no exposure to emerging market equities, whereas funds with high commonality have a much higher exposure to emerging market equities.
Second, the evidence demonstrates that funds with high commonality do not provide diversification benefits because of exposure to common risk factors. During the financial crisis, funds invested in emerging market equities had higher downside risk, negative skewness (skew), semi-deviation, and negative returns and were affected disproportionally by illiquidity—as measured by the higher median autocorrelation of individual funds—compared with associated developed market equity funds. The degree of serial correlation can be regarded as a proxy for the illiquidity exposure of the corresponding assets in a hedge fund portfolio.
In contrast, the funds with low commonality during the financial crisis had larger positive Sharpe ratios, positive mean returns and alpha, positive skew, and the lowest measures of semi-deviation, value at risk, expected shortfall, and tail risk. The authors also conclude that hedge funds with higher commonality had a higher degree of illiquidity. This result is not surprising because emerging market equities exhibit more liquidity risk than developed market equities when funds have to simultaneously close out their positions at greater losses.
How Did the Authors Conduct This Research?
The authors obtain data from Lipper TASS on 6,472 hedge funds for the period of January 1994–June 2009. The data include monthly individual hedge fund returns net of all fees, transaction costs, assets under management, policies, and investment strategies.
To measure the degree of commonality, the authors use principal component analysis and 12 risk factors to capture a broad range of asset classes. These risk factors include the returns on the MSCI North America, Europe, Pacific, and Emerging Market indices; the returns on portfolios of look-back straddle options on bonds, currency, and commodities; the monthly change in the 10-year US Treasury constant maturity yield; the monthly change in the Moody’s Baa rated yield less the 10-year US Treasury constant maturity yield; the return on the Deutsche Bank G10 Currency Carry Total Return index; the return on the variance swap; and monthly innovations in the Pastor and Stambaugh (Journal of Political Economy 2003) liquidity measure.
The authors explore the differences in summary statistics as a result of such downside risk exposures as semi-deviation, value at risk, expected shortfall, and tail risk in returns among the 10 commonality deciles. Also, the authors use the first-order autocorrelation coefficient proposed by Getmansky, Lo, and Makarov (Journal of Financial Economics 2004) to gauge hedge fund illiquidity risk exposure.
The literature review and empirical evidence the authors present confirm that hedge funds’ exposure to common factors reduces their diversification benefits and could pose a threat to the stability of the entire financial system. Following similar hedge fund investment strategies can trigger feedback loops involving asset prices and funding liquidity (Brunnermeier, Crocket, Goodhart, Persaud and Shin, Geneva Reports on the World Economy 2009), which can create adverse shocks in the financial sector that lead to hedge fund contagion.
The conclusions the authors draw regarding the performance of hedge funds invested in emerging market equities, rather than developed market equities, make sense for several reasons. First, emerging markets are more volatile than developed markets and can experience abnormally high growth rates compared with developed markets. Therefore, that higher growth drives larger returns during favorable economic periods. Second, during a shock to financial systems—for example, during the subprime crisis—investors fly to the relative safety of developed market equities and cash instruments. Practitioners may be able to achieve better returns by overweighting equity allocations in emerging markets during periods of growth and underweighting those allocations when uncertainty and economic contraction are foreseen.