The hedge fund industry has grown dramatically over the past two decades with estimated assets under management of $33 billion in 1990 and nearly $2 trillion in 2008. Part of the reason for this growth is that clients were promised ’absolute’(or positive) returns. Further, hedge funds supposedly offer portfolio diversification to investors because their investment style allows their returns to be uncorrelated with both equity market returns and with returns of hedge funds with different investment styles. However, in 2008 on average hedge funds lost 18% and the industry shrunk by a quarter reflecting both losses and client redemptions.

It is well known that correlations among equity markets are larger during large downward moves than during upward moves in equity prices. This phenomenon is generally referred to as contagion (Bekaert et al. (2005)). Can the same be said for hedge funds with different styles? Low correlation among different types of hedge funds motivate funds of hedge funds. The popularity of funds-of-funds is based on the notion that they offer the benefits of portfolio diversification by investing in hedge funds with different styles. The benefits of diversification are most important to investors during bad states. However, several studies including Boyson et al. (2008) have documented that hedge fund indices with different styles suffer from contagion. For instance in October 2008 the fifteen hedge fund style indices that are followed by CISDM all had negative returns ranging from -0.2% to -10%. More importantly the equity market neutral style index lost 2%!