The New York Federal Reserve has warned that hedge funds pose the greatest risk since the meltdown of Long-Term Capital Management in 1998.
In a paper published Wednesday, Fed capital markets economist Tobias Adrian blamed the recent high correlations among hedge-fund returns, which suggest concentrations of risk comparable with those preceding the LTCM crisis.
Adrian asserted, however, that the current increase in risk stems mainly from a decline in the volatility of returns, while the earlier rise in risk was driven by high covariances. In this context, covariance measures the extent to which hedge-fund returns move together, or apart, in dollar terms.
“Despite some seeming parallels between the recent and earlier rise in correlations,” stated the paper, “the current hedge fund environment differs from the 1998 environment because volatility and covariances now are lower.”
A lot is at stake.
Hedge funds — lightly regulated investment partnerships whose top managers’ personal earnings are capturing a lot of attention — currently manage an estimated $1.5 trillion, according to the Fed. The funds contribute more than half of average trading volume in equity and corporate bond markets.
“While the funds are major liquidity providers in normal times, their use of leveraged trading strategies has raised concerns about their liquidity effects in times of market stress,” according to the paper. In fact, the Fed asserted, the LTCM collapse seemed to confirm fears that heavy losses by hedge funds have the potential to drain significant liquidity from key financial markets.
Similar trading strategies employed simultaneously by a number of funds, the Fed elaborated, can heighten risk when the funds have to close out comparable positions in response to a common shock. In 1998, for example, many funds had to close out positions to meet margin calls and satisfy risk management constraints.
“If the returns of many funds are either high or low at the same time, the funds could record losses simultaneously, with possible adverse consequences for market liquidity and stability,” the Fed paper warned.
The Fed, which orchestrated a $3.6 billion bailout of LTCM that was privately funded by Wall Street banks, might also be concerned about the cost of another such implosion to the institutions it is charged with protecting. Many hedge funds borrow huge sums from banks so they can leverage their positions, especially in the derivatives markets.