THE JOURNAL OF FINANCE • VOL. LXV, NO. 5 • OCTOBER 2010 Hedge Fund Contagion and Liquidity Shocks

Defining contagion as correlation over and above that expected from economic funda-mentals, we find strong evidence of worst return contagion across hedge fund styles for 1990 to 2008. Large adverse shocks to asset and hedge fund liquidity strongly increase the probability of contagion. Specifically, large adverse shocks to credit spreads, the TED spread, prime broker and bank stock prices, stock market liquidity, and hedge fund flows are associated with a significant increase in the probability of hedge fund contagion. While shocks to liquidity are important determinants of performance, these shocks are not captured by commonly used models of hedge fund returns. USING MONTHLY HEDGE FUND INDEX DATA for the period January 1990 to October 2008, we find that the worst hedge fund returns, defined as returns that fall in the bottom 10 % of a hedge fund style’s monthly returns, cluster across styles. Further, using both parametric and semi-parametric analyses, we show that this clustering cannot be explained by risk factors commonly used to explain hedge fund performance. Bekaert, Harvey, and Ng (2005 p. 40) defin