Hedge Fund Return Volatility and Comovement : Recent Evidence

The purpose of this paper is to investigate the return performance of different investment strategies in the hedge fund sector, with a particular emphasis on the recent US financial crisis of 2007-2010. Additionally, the paper aims to investigate the comovement of hedge fund index returns. The paper identifies broad hedge fund investment strategies using data from the Dow Jones Credit Suisse Hedge Fund Database. It examines the return comovement using the cross-sectional volatility, covariance, and correlation metrics proposed in Adrian (2007). In addition, the paper examines whether correlations and covariance are important determinants of future volatility via traditional time-series regressions. The paper finds that the majority of the broad hedge fund investment strategies incurred record level losses and gains during the 2007-2010 period. In addition, it finds that the crisis period was preceded by high correlations, attributed primarily to a rise in cross-sectional hedge fund covariances. However, during the crisis period, a decrease in average correlations, stemming from an increase in hedge fund volatility, is documented. The time-series regressions are supportive of a strong relationship between cross-sectional covariances and subsequent volatility, suggesting that systemic risk occurs in the hedge fund sector when returns move significantly in dollar terms. This study is one of the first investigations that focus on the comovement and volatility of hedge fund index returns during the US financial crisis of 2007-2010