Anyone with school-aged children knows what September brings each year: colds. The common cold runs rampant through most schools beginning from the first days of the year. Seems the little whippersnappers regularly share toys, crayons, calculators and even their lunches with the sickest kid in the class.
The trouble is, we never know exactly who brought the cold to school in the first place. And as a result, we don’t know who to blame. Sure, we have our hunches. That little Evan Davies never washes his hands. Molly Abramsky is always dropping her lunch on the floor. Davie Schneider - that little wiener - spends most of the day with his finger planted firmly up his nose!
Caught off guard by the onslaught of foreign germs in September, our kids’ immune systems capitulate. But as the year wears on, they seem better able to resist the frequent cases of sniffles brought into class. Still, when someone comes into class with a violent hacking cough - no matter what time of year - that’s a whole other story.
As this New York Times piece piece on the weekend illustrates, hedge fund managers may not be that different from pre-schoolers. The Times cites a study (updated last month and available here) showing that hedge fund ”contagions” make kindergarten look like child’s play.
First, an important caveat: This study specifically says that hedge funds generally do not catch viruses from the equity, bond, or currency markets:
We find no systematic evidence of contagion from equity, fixed income, and currency markets to hedge fund indices…
And the paper goes on to cite a 2003 survey by State Street suggesting most institutional investors are motivated to invest in hedge funds for greater diversification. Ergo, implies this study, hedge funds fill an important role.
But while hedge funds are not prone to get sick when a bug is circulating through the broader financial community, they do tend to get each other sick on a frequent basis.
Unlike previous studies of hedge fund cross-correlation, this one examines the correlation between hedge fund sub-indices only during extreme events. Think of it as measuring the amount your child got sick when someone was coughing up a lung at recess - not just when someone had the sniffles on the bus. The researchers would say that your child’s health was related to that of their classmates in a “non-linear” fashion. In other words, they will respond differently depending on how sick their classmates are.
The study determines the level of correlation between each of eight hedge fund sub-strategies when one of them experiences a top 5% worst day ever. The results amount to a cheat sheet of how hedge funds have acted when one of their classmates shows up with chicken pox, head lice, and a scorching case of impetigo. In fact, we recommend you print page 36 of the paper and tape it to the side of your computer for easy access during market gyrations this fall.
That page shows which kids in the global hedge fund classroom have been sharing crayons, sitting next to each other - the ones most likely to get sick when certain others are also sick. In true academic form, the table is not inviting. So we broke out our own crayons and represent the data below.
(Key: MA - merger arbitrage, ED - event driven, DS - distressed securities, EH - equity hedge, MM - macro, EM - equity market neutral, RV - relative value, CA - convertible arbitrage. To keep things relatively readable, we have illustrated the contagious links “from” the bottom of each sub-strategy “to” the top of one of the other sub-strategies.)
While it looks a little like the British Airways route map, this diagram essentially shows which hedge funds were playing the same games and working at the same craft tables (i.e. effectively making the same fundamental bets). Note that Molly Abramsky, the Merger Arbitrage manager apparently never plays with Davie Schneider the Distressed Securities child prodigy. However, when Molly gets sick…Oh boy, watch out Evan Davies (of Event Driven fame).
Of 54 possible routes that a contagion might take between 8 sub-strategies, 27 of them where well-traveled between 1990 and 2006. Note that only 2 of these “extreme” correlations offer a hedge: Macro vs. Convertible Arb (due, we guess to their opposite dependencies on equities and bonds) and Event Driven and Equity Market Neutral (due, we guess, to the same factors). All sub-strategies play the same games as at least two other sub-strategies (and up to five others in the case of Event Driven).
Why so much cross-strategy susceptibility to contagions? The authors don’t know exactly. But they also hypothesize that hedge funds may be playing the same activities. Specifically, they all play “liquidity risk” - a slight modification of the traditional pre-school favorite ”hot potato”. They also suggest that when one fund needs to generate cash, it may sell off assets in another fund - thus causing problems for adjacent strategies.
Until we determine what these researchers call the “paths of contagion”, all we have is the traditional defenses with which we are so familiar: wash your hands, don’t share your lollypops, and for goodness sake, don’t wear each other’s hats.