Is There Hedge Fund Contagion?

Calling contagion the dependence in the probability of occurrence of extreme returns across different hedge fund styles and asset classes that cannot be explained by correlation, we find no systematic evidence of contagion between monthly returns on eight hedge fund styles and equity, bond, and currency markets. In contrast, the average probability that a style index has a return in the lower 10% tail increases from 1.67% to 39.92% as the number of other styles indices with a return in the lower 10% tail increases from 0 to 7. To explain this strong evidence of contagion across hedge fund styles, we investigate how the intensity of contagion depends on various proxies for funding liquidity and asset liquidity. We find that hedge fund contagion is magnified when prime brokerage firms have poor performance (which we would expect to affect hedge fund funding liquidity adversely) and when asset market liquidity is low. Commodity Trading Advisors (CTAs) are not subject to hedge fund contagion.