Hedge Funds and Financial Intermediaries

Abstract

Hedge funds and financial intermediaries are connected through their prime brokerage relationship. We find that systematic financial intermediary risk, as measured by the covariation between the hedge fund return and the return of a portfolio of key prime brokers, is important for understanding the cross-section of hedge fund returns. Once we control for the systematic risk, we find little evidence that idiosyncratic financial intermediary risk matters. We evaluate if large adverse shocks to individual prime brokers propagate to their clients, and find a significant impact only in the case of the Lehman bankruptcy. However, that impact was mitigated for funds with multiple prime brokers, suggesting even extreme prime broker shocks are diversifiable.