We’d rather not beat a dead horse, but the misinformation born out of the initial coverage of the Fed’s hedge fund report last week is spreading. In today’s (Monday’s) New York Post, for example, Fox News’ Terry Keenan writes that the Fed:
“…waved a red flag about the growing risks in the $1.4 trillion hedge fund industry. In fact, the Fed said the risks facing the financial system were the highest since the Long Term Capital crisis of 1998.”
We could find no such warning in the article we covered on the weekend, and have subsequently managed to find no such warning from any other sources. As we have written, the Fed said hedge fund strategy cross-correlation was coming off post-LTCM highs, but that correlation…
“…has a notable drawback…the correlation of different funds’ returns may rise either because the returns have moved more closely together (their covariance has increased) or because their volatility has fallen. As this article shows…an increase in the comovement of dollar returns was the leading cause of rising correlation in the 1990s, but a decline in overall volatility explains the recent rise.”
“…high correlations of returns generally do not precede increases in volatility in the hedge fund sector, but high covariances among hedge funds do.”
Keenan alleges that the Fed warned: “Similar trading strategies can heighten risk when funds have to close out comparable positions in response to a common shock.”
But that quotation explained why a high level of similarity could be problematic. It was not an actual conclusion of the report. The Fed’s actual words were:
“A key determinant of hedge fund risk is the degree of similarity between the trading strategies of different funds. Similar trading strategies can heighten risk when funds have to close out comparable positions in response to a common shock.”
Finally, Keenan provides what she seems to believe is evidence of hedge fund “group think”: UBS’s closure of its stand-alone proprietary hedge fund operation “due to staggering losses in the sub-prime mortgage market.”
She concludes, “How so many supposedly smart people were socked by sub-prime seems to support the Fed’s hunch that the ‘group think’ in hedge fund land could be a real problem.”
In our opinion, the coincidental absorption of one stand-alone unit managing $300 million back into a parent (UBS) that manages over $1 trillion is very weak evidence of “group think” across the entire industry.
This article reveals a great irony in popular hedge fund coverage: it’s actually the popular media that seems to be suffering from “group think”, not the hedge fund community.