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Hedge FundsStructure, Strategies, and Performance$
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H. Kent Baker and Greg Filbeck

Print publication date: 2017

Print ISBN-13: 9780190607371

Published to Oxford Scholarship Online: August 2017

DOI: 10.1093/oso/9780190607371.001.0001

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Financial Crises and Evaporating Diversification Benefits of Hedge Funds

Financial Crises and Evaporating Diversification Benefits of Hedge Funds

(p.439) 24 Financial Crises and Evaporating Diversification Benefits of Hedge Funds
Hedge Funds

Monica Billio

Mila Getmansky Sherman

Loriana Pelizzon

Oxford University Press

Diversification of risk is a potential benefit of investing in hedge funds. Using CSFB/Tremont hedge fund indices, this chapter shows that hedge fund strategies have different returns, volatility, and exposures to various systematic risk factors during tranquil times. This relation has led to the growth of the hedge industry and in particular funds of hedge funds, which provide diversification benefits by investing across different hedge fund styles. However, during financial crises, different hedge fund strategies are exposed to similar systematic risk factors. Most of the strategies become exposed to market liquidity and credit risk factors. Moreover, during the financial crises of 1998 and 2007–2008, all strategies were loading positively on the latent factor that induced positive correlation among hedge fund strategy residuals. As a result, diversification benefits incurred due to investing in different hedge fund strategies evaporated during these financial crises.

Keywords:   hedge fund, financial crisis, diversification, fund of hedge funds, credit risk, market liquidity

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