For several hours last Wednesday, major media outlets seemed to be broadcasting a hedge fund remake of Orson Welles’ famous rendition of War of the Worlds. Indeed, this recently published article by the New York Fed did begin by acknowledging that the correlations between different hedge fund strategies “suggest concentrations of risk comparable to those preceding the hedge fund crisis of 1998.”
But the article goes on to say that “…hedge fund covariance has increased, but it is not at particularly high levels by historical standards.”
This story, and the back-peddling done by the media after initially freaking everyone out last week, amounts to both a commentary on the pop-culture surrounding hedge funds and a reminder of a deeper statistical phenomenon that often leads to erroneous conclusions about hedge funds.
First, the media story (the statistics themselves are covered in the posting below)…
In an apparent rush to get the story to air (or print) several mainstream media outlets picked up the Chicken Little angle and ran with it on Wednesday. Examples:
Washington Post (1:05 PM, EDT): “Hedge fund risks worst since ’98 crisis, Fed says”
CNBC (2:07 PM EDT): “Hedge Fund Risk to Markets Highest Since 1998: New York Fed“
In fact, if you click on the video link in the CNBC story, you’ll hear Liz Claman break into the schedule with this news update that would have made Welles proud:
“We have an alert here to tell you about. There is a paper than has been written by an economist over at the New York Fed that is just becoming public here. This economist is warning that the level of risk now seen among hedge funds may match that which we saw during the meltdown of hedge fund Long Term Capital Management…(The paper says) hedge funds are now reaching the level of risk that we saw back in the 1990s.”
But perhaps the funniest part of CNBC’s coverage is the way Carl Quintanilla takes the hand-off from Claman:
“…No reaction from the markets at this moment. But we’ll keep an eye on what that does to the markets later on today.”
It’s as if they were surprised markets hadn’t gone into a tailspin. In a blow to CNBC’s afternoon advertisers, markets didn’t take this story too seriously and no sensational doomsday scenario unfolded later that day. Why? Probably because the report was entirely misinterpreted in the rush to announce the imminent death of hedge funds.
By 4:35PM, Reuters has issued an “Update” to their earlier story “recast with additional details”. The story also had a new title: “Hedge fund risk highest since LTCM, with a twist” (our emphasis).
Here are a few of the “additional details” contained in that update:
“…However, reduced market fluctuations are probably overstating the dangers, the study said…”
“…’The unusually high correlation among hedge funds in the current environment is therefore attributable primarily to low hedge fund volatility,’ (the Fed’s) Tobias wrote…”
In addition, what Reuters initially called “The bank’s sternest warning to date”, had been downgraded to “the study represents a stern warning”. (note that the study is now tied to the warning, not the bank itself).
And thus, the story became a shadow of its former self. By the next morning, the media was running decidedly more bland headlines such as:
Financial Times (Thursday, 4:07 AM EDT): “Hedge funds pose a risk, but less alarming, says NY Fed”
The Toronto Star (Thursday, 4:30 AM EDT): “Study downplays hedge funds as market threat”
FinAlternatives (Thursday): “Another LTCM In The Cards? Not Quite, Says N.Y. Fed“
It turns out that the sky was not falling and the aliens weren’t attacking. As the Financial Times adroitly noted on Thursday:
It’s entirely likely that we have also made mistakes interpreting research at AllAboutAlpha. So we can’t blame Reuters alone for making too much of this report. But the fact that the mainstream media seemed positively giddy with excitement over the initial story should give us pause.
In any case, that’s the media angle to this story. But the original source of this confusion is worthy of its own posting. That story follows…