Hedge Fund Styles and their Contagion from the Equity Market

• Author: Tae Yoon Kim,Hee Soo Lee
• Date: 01 March 2018
• Published date: 01 March 2018
• DOI: http://doi.org/10.1111/irfi.12141

Hedge Fund Styles and their

Contagion from the Equity Market*

HEE SOO LEE

†

AND TAE YOON KIM

‡

†

Department of Business Administration, Sejong University, Seoul, Korea and

‡

Department of Statistics, Keimyung University, Daegu, Korea

ABSTRACT

We examine the dynamic contagion process of the equity market on 10 hedge

fund styles. We investigate the contagion mechanism for each style using

single equation error correction and latent factor models. We find that the

contagion effects of the equity market on each style index depend specifically

on the fund style strategy. We demonstrate that certain fund styles are more

prone to contagion from the equity market than others. Our results help

illuminate the relative effectiveness of a particular strategy under certain

market conditions and provide insights into the long-standing controversy

around the efficient market hypothesis.

Accepted: 30 May 2017

I. INTRODUCTION

Investors are primarily concerned with seeking secure, steady returns during both

bull and bear markets. Hedge funds are attractive options for investors because

they demonstrate weak correlation to standard asset classes compared to

traditional investments (e.g., standard equity investing). Hedge funds have

claimed that maintaining steady returns is possible by arbitrage, forecasting, or

investment diversification and that such funds are uniquely suited for risk

aversion in dynamic and volatile equity markets (Brown et al. 1999; Agarwal

and Naik 2000, 2004; Edwards and Caglayan 2001; Boyson et al. 2006; Li and

Kazemi 2007). In a mean–variance environment, hedge funds have enjoyed

growing popularity since their introduction in the 1990s. However, the role of

hedge funds in financial markets has become a controversial issue in recent

history because of large losses by high profile hedge funds prior to, and

subsequent to, the Global Financial Crisis (GFC). The collapse of Long-Term

Capital Management (LCTM), known as a fixed income arbitrage (FIA) fund, in

1998, the Soros Fund in 2000, and Amaranth in 2006 preceded the demise of

the Bear Sterns funds in 2008 at the onset of the GFC, which, in turn, heralded

* The authors thank the anonymous referees for valuable comments and suggestions. H. S. Lee’s

work is supported by Sejong University, and T. Y. Kim’s work is supported by the National Research

Foundation of Korea (NRF 2016R1D1A1B03934375).

© 2017 International Review of Finance Ltd. 2017

International Review of Finance, 2017

DOI: 10.1111/irfi.12141

International Review of Finance, 18:1, 2018: pp. 91–112

DOI:10.1111/irfi .12141

© 2017 International Review of Finance Ltd. 2017

the start of further collapses for investment banks and other hedge funds.

Investors, regulators, and the financial press have expressed concerns about

particular hedge fund bankruptcies and criticized the hedge fund industry in

general. Hedge fund criticsclaim that direct contagion from the equity market ex-

ists in hedge funds, particularly in crisis periods, and therefore fund investors do

not derive the expected benefits of diversification (Viebig and Poddig 2010). Here,

the direct contagion from the equity market conceptually implies excessive domi-

nance of the equity market over the hedge funds or too large an exposure of the

hedge funds to the equity markets. In fact, these concerns are rooted in the long-

standing controversy around whether hedge funds are capable of manipulating fi-

nancial market movements and bringing large profits to their investors (e.g.,

Ackermann et al. 1999). Given that not all hedge fund strategies have the same

exposure to the equity markets, it is critical and fair for hedge funds and their

investors toinvestigate which fund stylesare more prone to contagion than others.

In this paper, we explore a transmission mechanism of equity market crisis to

each hedge fund style, which involves investigating the contagion for each

hedge fund style. For this, we define the break in the short- and long-term

relation between each hedge fund style and equity market. We also define inter-

dependence as a scaled long-term relation between each hedge fund style and the

equity market, and then define contagion as the break in the interdependence. In

addition, we define a break point as a measure for the precise activation of short-

or long-term breaks or contagion. These definitions are given precisely through a

single equation error correction model (SEECM) that our methodology is based

on, together with latent factor model, quantile regression, and the Wald–

Wolfowitz runs test. Using return data from Credit Suisse hedge fund style

indices and US equity market index from January 1994 to December 2012, we

analyze how financial crises spread from equity market to each hedge fund style.

Our results show that the effects of the equity market on each hedge fund style in-

dex specifically depend on the strategies of each fund style. We find three groups

of hedge fund index returns, each with a different relationship with equity market

returns. The volatility group, based on arbitraging volatility, is found to be

significantly more affected by the equity market during crisis periods. Whereas,

the direction group, based on directional forecasting, appears to have chance of

making consistent profits by recovering its independence from the equity market.

The pool group, based on pooled or diversified strategies, shows a relatively stable

relationship with equity market returns across entire periods. In addition, it is

worth mentioning that our results provide some useful insights into the

long-standing controversy around the efficient market hypothesis (EMH).

1

To explore these issues in greater detail, we have organized this paper into a

series of interrelated sections. In Section ii, we explain the methodology based

on the SEECM. This explanation contains precise definitions for short- and

long-term breaks and the interdependence break (defined as contagion). We also

1 EMH states that it is impossible to “beat the market”as stock market efficiency causes existing

share prices to always incorporate and reflect all relevant information.

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