Hedge funds and Private Equity - PES

time peak in 2005.” It is important to note the fact that correlations are rising not only within some
strategies, but also among strategies, raising concerns that some triggering event could lead to
highly correlated exits. Furthermore, the ECB has stressed that “… the levels reached in late
2005 exceeded those that prevailed just before the near-collapse of the LTCM …” 70 .
Medians of pair wise correlation coefficients
of monthly hedge fund returns within strategies
(Jan. 1995-Dec. 2005, monthly net of all returns in USD)
0.8 0.8
0.7 0.7
0.6 0.6
0.5 0.5
0.4 0.4
0.3 0.3
0.2 0.2
0.1 0.1
0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Sources: ECB Financial Stability Review, June 2006. (Numbers in parentheses after strategy
indicate the share of total capital under management (excluding FOHFs) at the end of 2005.)
There may be a number of reasons for high correlations. In the case of the LTCM crisis (see box
1) many of the virtual, statistical models used by hedge funds and other players in financial
markets led to the same kind of behaviour. In the case of LTCM it also seems as if the brokers,
who received order flow information through their dealings with LTCM, took similar positions
alongside their client. In the more recent case of the hedge fund Amaranth (see box 2), the
reason for its default does not appear to lie especially in excess of leverage but in an unsatisfactory
management approach, which underestimated the correlation among different bets and
the problematic concentration on a single thin market like the market for natural gas. Amaranth’s
position represented a significant share of the whole market. Consequently, it was difficult to
unwind the fund’s portfolio when things begun to get worse.
Despite the increasing correlations, the more recent default of the hedge fund Amaranth did not
appear to have threatened or even influenced financial market stability (see box 2). Thus, there
has been an absolute absence of contagion spreads over the other financial markets: No volatility
spikes were registered during September 2006, neither on the stock markets, nor on the bond
markets. Furthermore, the commodity market itself did not show any sign of fear as the ordinary
price behaviour of the CRB index in September 2006 testifies. Nonetheless the absence of
contagion spreads in the Amaranth case is no assurance that hedge funds have become any
more robust. One of several important differences to the LTCM crisis of 1998 was the situation
of global financial markets. In 1998 they were under extreme stress in the aftermath of the
Russian crisis. In 2006 they were awash with cash after many years of loose monetary policy.
70 ECB (2006): ibid., p. 135.
Fund of funds
Convertible arbitrage (3%)
Long/short equity hedge
(32%)
Multi-strategy (13%)
Part II – Six concerns about our European social market economy
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