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Systemic Risk and Cross-Sectional Hedge Fund Returns

The hedge fund industry has been one of the most rapidly growing areas of the financial sector over the last decade. Its rapid growth results from its important benefits to financial markets and investors in the form of improved investment opportunity, price discovery, liquidity, risk sharing, and portfolio diversification. For example, hedge funds have provided funds to build infrastructures in emerging countries over the past years.

In spite of these benefits, the role of hedge funds in the financial system has been controversial, because they can be a source of systemic risk1 to the financial system, potentially exacerbating market failures. These concerns have especially deepened since the market collapse triggered by Long-Term Capital Management in 1998 and the recent U.S. subprime crisis.

The relation between hedge fund and systemic risk can be described conceptually as the linkage from hedge funds to real economic activity. To be more exact, hedge funds can pose systemic risk by obstructing the ability of financial intermediaries or the financial market to efficiently provide credit through several different mechanisms, or channels (see, e.g., Chan et al., 2006; McCarthy, 2006; Hildebrand, 2007; Kambhu, Schuermann, and Stiroh, 2007). The first channel is the direct risk exposure of financial institutions to hedge funds.

Financial intermediaries are directly connected to hedge funds through their counterparty credit risk exposures, as in prime brokerage activity, short-run financing for leveraged positions, and trading counterparty exposures in over-the-counter and other markets. If a bank has a large exposure to a hedge fund that fails or suffers losses on its investments, the increased risk exposure or eroded bank capital may reduce its ability or willingness to provide credit to worthy borrowers. The second channel is disruptions to the efficient functioning of capital markets that impede credit provision.

Such disruptions fundamentally reflect a reduced ability or willingness to bear risk through credit provision due to the loss of investor confidence. The third channel is indirect effects of the feedback of the bank problem in broader financial markets. Because financial intermediaries provide a significant source of liquidity to the hedge fund industry, a shock induced by hedge funds to financial intermediaries can trigger a chain reaction by reducing the liquidity provision of these banks to other hedge funds or to other banks, thus leading to financial market disruption.

Systemic Risk and Cross-Sectional Hedge Fund Returns