Detecting Early Warnings for Hedge Fund Contagion

In this paper we investigate contagion dynamics in the hedge fund industry and explore their main symptoms and implications for systemic risk. Correlations in hedge fund returns, their leverage dynamics, and market liquidity shocks are commonly classified as the main systemic risk drivers in the hedge fund industry. How they can be assembled in order to detect hedge fund contagion? In this paper we try to give an answer to this question by realizing an Early Warning System for hedge funds based on specific red flags that help to detect symptoms of impending contagion effects. Our empirical findings revealed a changing nature of contagion which has important implications for investors and asset managers, in particular regarding the role played by correlations in portfolio construction and portfolio risk management.
Keywords: Hedge funds; Contagion; Dynamic conditional correlations; Time-varying beta;
Regression trees.
JEL codes: C11; C14 ; G10.