Systemic Risk and Hedge Funds∗

Systemic risk is commonly used to describe the possibility of a series of correlated defaults among financial institutions—typically banks—that occur over a short period of time, often caused by a single major event. However, since the collapse of Long Term Capital Management in 1998, it has become clear that hedge funds are also involved in systemic risk exposures. The hedge-fund industry has a symbiotic relationship with the banking sector, and many banks now operate proprietary trading units that 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. In this paper, we attempt to quantify the potential impact of hedge funds on systemic risk by developing a number of new risk measures for hedge funds and applying them to individual and aggregate hedge-fund returns data. These measures include: illiquidity risk exposure, nonlinear factor models for hedge-fund and banking-sector indexes, logistic regression analysis of hedge-fund liquidation probabilities, and aggregate measures of volatility and distress based on regime-switching models. Our preliminary findings suggest that the hedge-fund industry may be heading into a challenging period of lower expected returns, and that systemic risk is currently on the rise. Prepared for the NBER Conference on the Risks of Financial Institutions. The views and opinions expressed in this article are those of the authors only, and do not necessarily represent the views and opinions of AlphaSimplex Group, MIT, the University of Massachusetts, or any of their affiliates and employees. The authors make no representations or warranty, either expressed or implied, as to the accuracy or completeness of the information contained in this article, nor are they recommending that this article serve as the basis for any investment decision—this article is for information purposes only. Research support from AlphaSimplex Group and the MIT Laboratory for Financial Engineering is gratefully acknowledged. We thank Mark Carey, David Modest, René Stulz and participants of the NBER Conference on The Risks of Financial Institutions for helpful comments and discussion. Parts of this paper include ideas and exposition from several previously published papers and books of some of the authors. Where appropriate, we have modified the passages to suit the current context and composition without detailed citations and quotation marks so as preserve continuity. Readers interested in the original sources of those passages should consult Getmansky (2004), Getmansky, Lo, and Makarov (2004), Getmansky, Lo, and Mei (2004), and Lo (2001, 2002). AlphaSimplex Group, LLC, One Cambridge Center, Cambridge, MA 02142. Isenberg School of Management, University of Massachusetts, 121 Presidents Drive, Room 308C, Amherst, MA 01003, (413) 577–3308 (voice), (413) 545–3858 (fax), [email protected] (email). AlphaSimplex Group, LLC, One Cambridge Center, Cambridge, MA 02142. MIT Sloan School of Management, and AlphaSimplex Group, LLC. Corresponding author: Andrew Lo, MIT Sloan School, 50 Memorial Drive, E52-432, Cambridge, MA 02142–1347, (617) 253–0920 (voice), (617) 258–5727 (fax), [email protected] (email).