Fed Research Clarifies Current Hedge Fund Risk Environment

May 2, 2007 (PLANSPONSOR.com) - While some have raised risk concerns about leveraged trading by hedge funds, a new study asserts that the naysayers may not have that much to worry about.

In a research paper prepared for the Federal Reserve Bank of New York, Measuring Risk in the Hedge Fund Sector, author Tobias Adrian contends that the current hedge fund trading environment is distinctly different than that of 1998 when the hedge fund Long-term Capital Management (LTCM) collapsed.

The fear, according to Adrian, is that “heavy losses by hedge funds have the potential to drain significant liquidity from key financial markets.”

On examining the runup to the LTCM debacle and current hedge fund results, Adrian contends that the correlation of hedge fund returns rose both in the late 1990s and in recent months. However, in the early period, Adrian says, the correlation was primarily driven by rising comovement of dollar returns, while the leading cause of such correlation recently was a decline in overall volatility.

The paper also argues that high correlation of hedge fund returns generally do not precede increases in the hedge fund sector’s volatility, but high covariance (the extent to which hedge fund returns move together or apart in dollar terms) among hedge funds do.

High correlation and high covariance in an environment of increased hedge fund return volatility characterized the LTCM collapse, but Adrian contends that the current environment is characterized by only average levels of covariance 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,” he said.

According to Adrian, increases in hedge fund covariance tend to lead to higher volatility, which suggests comovement measured in dollars – covariance – is a more relevant indicator of risk than comovement measured in correlation, that is, covariance normalized by volatility.

“The unusually high correlation among hedge funds in the current environment is attributable primarily to low hedge fund volatility – a reflection of the generally low volatility of financial assets,” the researcher asserts.

The research report is here .