Do Hedge Funds Increase Systemic Risk?

Nicholas Chan, Mila Getmansky, Shane M. Haas, and Andrew W. Lo
Economic Review, Vol. 91, No. 4, 2006

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Although hedge funds have typically yielded double-digit returns, their dynamic investment strategies entail risks that differ in important ways from those of more traditional investments. The proliferation of hedge funds in recent years may have significant implications for systemic risk.

This article considers hedge funds' impact on systemic risk by examining their unique risk-and-return profiles at both the individual-fund and the aggregate-industry levels. Because liquidity is one of the central aspects of systemic risk, the authors present several indirect measures for gauging illiquidity exposure in hedge funds and other asset classes.

Systemic risk is directly related to hedge fund failures, so the authors investigate attrition rates of individual hedge funds and present a logit analysis that yields estimates of a fund's probability of liquidation as a function of various fund characteristics. To capture some dynamic factors unique to the hedge fund industry, the authors also present estimates of statistical regime-switching models for hedge fund indexes.

The study's findings suggest that hedge funds may be facing a period of lower expected returns and that systemic risk may be rising. To address these challenges, the authors propose that a new entity, patterned after the U.S. National Transportation Safety Board, be established to investigate hedge-fund liquidations and provide public recommendations for improving the stability and robustness of global financial markets.

December 2006