The Effect of Monetary Policy on Hedge Fund Returns: A Financial Application of Macroeconomics, Evidence from Federal Reserve Policy in 1990, 1994, 2001, and 2004

Abstract

In this paper, I set out to investigate the effect that monetary policy has on hedge fund performance. I use detailed data on hedge funds from 1990-2004 and look at major Federal Reserve policy from 1990, 1994, 2001 and 2004—including two Federal Funds Rate hikes and two Federal Funds Rate cuts of at least 275 basis points—employing a difference-in-difference methodology for four separate event studies to determine an answer to this question. Additionally, the majority of my analysis looks into cross-sectional variations. Specifically, I investigate to what extent changes in monetary policy affect the performance of different types of hedge funds. I determine, for example, the effect that monetary policy has on funds that follow a long/short equity strategy versus the effect on funds using an event driven strategy, and then compare the difference between the two effects. I find that an increase in interest rates has a mixed effect on long/short equity hedge funds and global macro hedge funds but a strictly negative effect on event driven hedge funds, a strictly negative effect on fixed income arbitrage hedge funds, and a mixed effect on all hedge funds in aggregate. I also find that a decrease in interest rates has a mixed effect on long/short equity hedge funds and global macro hedge funds, but a strictly positive effect on event driven hedge funds and a strictly negative effect on all hedge funds in aggregate. In the end, the results seem to further underscore the puzzle of identification in macroeconomics. While we gain a much deeper understanding of hedge fund returns by industry and by event, the problem of identification reminds us how imprecise this macroeconomic analysis can be due to endogeneity concerns.