Fed Found, and Dismissed, Signs of High Correlation in Hedge Fund Strategies

It’s summer rerun time. By happenstance, I came across a May post, which referred to a Federal Reserve study that had found that risks of hedge funds pursuing highly correlated strategies appeared, by some measures, as high as before the LTCM crisis.

We had thought the Fed might be making a mistake in dismissing its risk-o-meter:

The findings, at least for the Fed, are pretty dramatic. On the one hand, it warns that according to some measures, hedge funds now pose as big a risk to the financial system as they did right before the Long Term Capital Management meltdown. On the other, the Fed argues that the causes for the risk metrics being so high this time come from different, less troubling causes.

The signal is high correlation of returns. Tobias Adrian, the economist who produced the study, concludes that the correlation this time is due to low volatility, while 10 years ago, more variable hedge fund returns nevertheless moved together.

The problem is that the presence of low volatility doesn’t necessarily prove that the hedge fund returns aren’t somehow correlated in ways that bode ill for financial stability. As we mentioned earlier, a recent analysis in Risk Magazine found that credit risks are more tightly linked than most observers believe (and recall that many hedge funds pursue credit-market trading strategies).

Now we know that some quants, particularly the large ones, were pursuing highly correlated strategies. They came often came from the same schools and the same firms, socialized together, and therefore, not surprisingly, thought along broadly the same lines.

But, in fairness to the Fed, even if it had taken this signal seriously, what could it have done? It has no formal regulatory over investment banks, and hedge funds are beyond anyone’s reach. But the Fed does have a powerful bully pulpit which it has been hesitant to use (by contrast, our hero Ian MacFarlane, former Governor of the Reserve Bank of Australia, took the air out of Australia’s housing bubble mainly through moral suasion).

Taking the possibility of LTCM-like risk more seriously, and talking it up, might well have mitigated the outcome.

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