Hedge Fund Return Dependence and Liquidity Spirals

Abstract

Different types of hedge funds tend to suffer poor abnormal returns simultaneously. Moreover, the likelihood of clustering in hedge fund left tail abnormal returns is positively related to negative liquidity shocks. These patterns have been interpreted as evidence that hedge funds suffer from liquidity shock induced contagion. We provide novel tests that demonstrate these patterns result from model misspecification and time-varying heteroskedasticity rather than liquidity shock induced contagion. Our results have important implications for understanding how markets function, the role of hedge funds in markets, and hedge fund regulation.

Keywords: Hedge funds; contagion; liquidity shocks

JEL Classification: G01, G12, G14, G18, G23