Dynamic Linkages between Hedge Funds and Traditional Financial Assets: Evidence from Emerging Markets

This paper analyses the shortand long-term relationships between hedge funds and traditional financial assets for the main emerging market regions of Asia, Latin America, and Eastern Europe by using multivariate cointegration analysis. Because cointegrated assets are tied together over the long term, a portfolio consisting of these assets lowers uncertainty and should therefore be preferred by risk-averse investors. In addition, long-term (passive) investors can benefit from the knowledge of cointegrating relationships, while the built-in error correction mechanism allows active asset managers to anticipate short-term price movements. To detect the shortand long-term dynamics between these asset categories, we specify a vector error correction model (VECM). In a Granger causality sense, only in Asia do we see a long-term causal relationship that runs from hedge funds and stocks to bonds. In Latin America, traditional asset markets influence hedge fund prices over the long term. In contrast, in Eastern Europe price series are strongly endogenous, which is suggested by bidirectional shortand long-term causality. Moreover, these results are supported by variance decomposition (VDC). As to whether diversification benefits arise from adding emerging markets hedge funds to an emerging markets bond/equity portfolio, it is obvious that the advantages are significantly less for Eastern Europe than for the other emerging market regions.