Hedge Fund Contagion and Risk-Adjusted Returns: A Markov-Switching Dynamic Factor Approach

Posted: 1 May 2013

See all articles by Ozzy (Ozgur) Akay

Ozzy (Ozgur) Akay

Office of Financial Research, US Department of the Treasury

Zeynep Senyuz

Board of Governors of the Federal Reserve System

Emre Yoldas

Board of Governors of the Federal Reserve System

Date Written: July 18, 2012

Abstract

We provide an empirical analysis of two important phenomena influencing the hedge fund industry - contagion and time variation in risk adjusted return (alpha) - in a flexible unified framework. After accounting for standard hedge fund pricing factors, we quantify the common latent factor in hedge fund style index returns and model its time-varying behavior using a dynamic factor framework featuring Markov regime-switching. We find that three regimes - crash, low mean and high mean - are necessary to provide a complete description of joint hedge fund return dynamics. We also document significant time variation in the alpha generating ability of all hedge fund investment styles. The period following the stock market crash of 2000 is dominated by the persistent low return state while the long bull market of 1990s is associated with the strongest performance of the industry generating high positive returns. We also investigate drivers of the regime shifts in the common latent pricing factor and find that both flight to safety and large funding liquidity shocks play an important role in explaining the abrupt shift of the common factor to the crash state.

Keywords: Hedge fund, Contagion, Risk-adjusted return, Dynamic factor models, Markov-switching, Funding liquidity, Flight to safety

JEL Classification: G01, C32, C58

Suggested Citation

Akay, Ozzy (Ozgur) and Senyuz, Zeynep and Yoldas, Emre, Hedge Fund Contagion and Risk-Adjusted Returns: A Markov-Switching Dynamic Factor Approach (July 18, 2012). Journal of Empirical Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2217667

Ozzy (Ozgur) Akay

Office of Financial Research, US Department of the Treasury ( email )

717 14th Street, NW
Washington, DC 20005
United States
202-927-8274 (Phone)

Zeynep Senyuz

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Emre Yoldas (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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