LO 71.8: Describe market events that resulted in a convergence of risk factors for

LO 71.8: Describe market events that resulted in a convergence of risk factors for different hedge fund strategies, and explain the impact of such a convergence on portfolio diversification strategies.
Theoretically, diversification among hedge fund strategies should protect investors, but there are certain events that affect all, or mostly all, strategies, as they all undergo stress at the same time. Portfolio diversification implodes, and seemingly diverse hedge fund portfolios converge in terms of risk factors during times of stress.
The first recorded major market event for hedge funds was in March and April of 1994 when unexpected changes in interest rate policy were set by the Federal Reserve. This caused two months of losses by seven of the ten style-specific sub-indices in the DJCS family. Exceptions were short sellers and managed futures funds. Merger arbitrage funds earned a positive return in March, while equity market neutral funds had a positive return in April.
Another major event was in August 1998 right before the collapse of LTCM. Eight of the ten niche DJCS style sub-indices had large losses. Short sellers and managed futures funds avoided losses. The losses occurred primarily due to market-wide liquidation of risky assets and the high amount of leverage on LTCMs balance sheet.
With hedge fund investing, leverage has a magnifying effect on gains and losses, and risk is on both sides of the balance sheet. There were events prior to the 20072009 financial crisis that illustrated how much a market-wide funding crisis can significantly impair leveraged positions. In August 2007, for the first time, all nine specialist style sub-indices lost money. The only positive return was from short sellers. During the peak of the financial crisis from July to October 2008, July to September brought losses for all hedge fund styles (excluding short sellers). When leveraged positions are forced to liquidate, losses can be high.
The point is that when there is a market-wide funding crisis, it is difficult to mitigate risk by simply spreading capital among different hedge fund strategies. There is significant credit-driven tail risk in a hedge fund portfolio. The use of managed futures may be a partial solutionit has been a strategy with a convex performance profile relative to other hedge fund strategies. Hedge fund investors need to consider portfolio risks associated with dramatic market events.
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