We measure the commonality in hedge fund returns, identify its main driving factor and analyze its implications for financial stability. We find that hedge funds’ commonality increased significantly from 2003 until 2006. We attribute this rise mainly to the increase in hedge funds’ exposure to emerging market equities, which we identify as a common factor in hedge fund returns over this period. Our results show that funds with a high commonality were affected disproportionately by illiquidity and exhibited negative returns during the subsequent financial crisis, thereby providing little diversification benefits to the financial system and to investors.

We use logit and Markov switching models to assess, in (pseudo-)real-time, the ability of 27 indicators to predict systemic financial crises in the European Union. Before the global financial crisis (GFC), some models provided early warning signals, but it is unclear whether a specific model would have been favored over other candidate models providing contradictory evidence. Only after the GFC do debt service ratios, credit-to-GDP gaps as well as house price-to-income and house price-to-rent ratios appear as robust early warning indicators. Our results highlight that the predictive ability of indicators may change due to new risk factors or policy actions.

This paper introduces a new methodology to date systemic financial stress events in a transparent, objective and reproducible way. The financial cycle is captured by a monthly Country-Level Index of Financial Stress (CLIFS). Based on two Markov-switching and one threshold vector autoregressive model, information from the CLIFS and industrial production are combined to identify those episodes of financial market stress that are associated with a substantial negative impact on the real economy. By applying this framework to 27 European Union countries, the paper is a first attempt to provide a chronology of systemic financial stress episodes as a complement to the expert-detected events that are currently available.