Defining contagion as correlation over and above that expected from economic fundamentals, we find strong evidence of worst return contagion across hedge fund styles for 1990 to 2008. Large adverse shocks to asset and hedge fund liquidity strongly increase the probability of contagion. Specifically, large adverse shocks to credit spreads, the TED spread, prime broker and bank stock prices, stock market liquidity, and hedge fund flows are associated with a significant increase in the probability of hedge fund contagion. While shocks to liquidity are important determinants of performance, these shocks are not captured by commonly used models of hedge fund returns. Copyright (c) 2010 the American Finance Association.
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.
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