SSRN-Systemic Risk and Hedge Funds by Nicholas Tung Chan, Mila Getmansky, Shane Haas, Andrew Lo

Continuing the discussion on Hedge Funds and their regulation, Chan, Getmanksy, Haas, and Lo have some important contributions to make. Their paper Systemic Risk and Hedge Funds by Nicholas Tung Chan, Mila Getmansky, Shane Haas, Andrew Lo (which is being presented at the 2005 EFA conference paints a picture of banks being exposed to the hedge fund industry and the hedge fund industry being quite exposed to a series of risks. Together these factors are seen as increasing systematic risk.

Longer review:

Some quotes from their paper (which btw is 110 pages long):

* "innovations in the banking industry have coincided with the rapid growth
of hedge funds, unregulated and opaque investment partnerships that engage in a variety of active investment strategies, often yielding double-digit returns and commensurate risks. Currently estimated at over $1 trillion in size, the hedge fund industry has a symbiotic relationship with the banking sector, providing an attractive outlet for bank capital, investment management services for banking clients, and fees for brokerage services, credit, and other banking functions. Moreover, many banks now operate proprietary trading units which are
organized much like hedge funds. As a result, the risk exposures of the hedge-fund industry may have a material impact on the banking sector, resulting in new sources of systemic risks. And although many hedge funds engage in hedged strategies --—where market swings are partially or completely offset through strategically balanced long and short positions in various securities--—such funds often have other risk exposures such as volatility risk, credit risk, and liquidity risk."

The authors identify two themes:

"We argue that the risk/reward profile for most alternative investments differ in important ways from more traditional investments, and such differences may have potentially important implications for systemic risk, as we experienced during the aftermath of the default of Russian government debt in August 1998 when Long Term Capital Management and many other hedge funds suffered catastrophic
losses over the course of a few weeks, creating significant stress on the global financial system and a number of substantial financial institutions. Two major themes emerged from that set of events: the importance of liquidity and leverage, and the capriciousness of correlations among instruments and portfolios that are supposedly uncorrelated. These are the two main themes of this study, and both are intimately related to the dynamic nature of hedge-fund investment strategies and risk exposures."

The authors go on to explain that because of the dynamic nature of hedge funds, there currently exists no single measure of risk and that the benefits of diversification (as shown through standard Mean-Variance diagrams) may be distorted by changing correlations. Moreover, with the exposure to "tail risk" included, it is often difficult to guage the actual risk to return performance. After providing an example of this, they argue that investors do not fully appreciate this risk:

"The track record in Tables 2 and 3 seems much less impressive in light of the simple strategy on which it is based, and few investors would pay hedge-fund-type fees for such a fund. However, given the secrecy surrounding most hedge-fund strategies, and the broad discretion that managers are given by the typical hedge-fund offering memorandum, it is difficult for investors to detect this type of behavior without resorting to more sophisticated risk analytics that can capture dynamic risk exposures."

I really can not do the paper justice without going into too much detail (did I mention the 110 pages?), but I will share their conclusions:

"...Therefore, we cannot determine the magnitude of current systemic risk exposures with any degree of accuracy. However, based on the analytics developed in this study, there are a few tentative inferences that we can draw.

1. The hedge-fund industry has grown tremendously over the last few years.... These massive fund inflows have had a material impact on hedge-fund
returns and risks in recent years, as evidenced by changes in correlations, reduced
performance, increased illiquidity...and increased mean and median liquidation probabilities for hedge funds in 2004.

2. The banking sector is exposed to hedge-fund risks, especially smaller institutions, but the largest banks are also exposed through proprietary trading activities, credit arrangements and structured products, and prime brokerage services.

3. The risks facing hedge funds are nonlinear and more complex than those facing traditional asset classes....

4. ....Recent measurements suggest that we may be entering a challenging period. This, coupled with the recent uptrend in the weighted autocorrelation ρ∗t , and the increased mean and median liquidation probabilities for hedge funds in 2004 from our logit model implies that systemic risk is increasing.

We hasten to qualify our tentative conclusions by emphasizing the speculative nature of these inferences, and hope that our analysis spurs additional research and data collection to refine both the analytics and the empirical measurement of systemic risk in the hedge-fund industry."

Wow. Well done. Whether you agree or disagree with their conclusions, after looking over their work (this entry took about three times as long as a "typical blog entry"--did I mention it is 100 pages?), I am sure you will acknowledge the importance of the questions they raise.

a definite I^3 paper! (interesting, informative, and important)

Cite:

Chan, Nicholas Tung, Getmansky, Mila, Haas, Shane M. and Lo, Andrew W., "Systemic Risk and Hedge Funds" (February 22, 2005). http://ssrn.com/abstract=671443