The Federal Reserve Bank of New York said on Wednesday that the risk hedge funds pose to the global financial system has reached levels by some measures comparable to those just before the Long Term Capital Management fund imploded in 1998, reports the FT on Thursday.
But the New York Fed said the similarities – involving close correlation among hedge fund returns seen before the LTCM crisis and again recently – had different causes, making the current environment less alarming.
The bank’s study is the latest contribution to a debate that has seen regulators and analysts express concern over the risks and leverage taken on by hedge funds, the private investment vehicles that are increasingly influential in financial markets. The hedge fund industry has mushroomed in recent years and now accounts for an estimated $1,500bn (£749.7bn) of investments.
“While the funds are major liquidity providers in normal times, their use of leveraged trading strategies has raised concerns about their liquidity effects in times of market stress,” said study author Tobias Adrian, an economist in the capital markets research group at the New York Fed. He cited the LTCM experience as evidence that heavy hedge fund losses could drain trading liquidity from financial markets.
Mr Adrian said the recent high correlation of hedge fund returns stems mostly from their low volatility, a less reliable signal of future turbulence than a decade ago when the rise in correlation owed more to funds’ more volatile returns moving in lockstep.
Er…phew?