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The possibility of a “domino effect” in the hedge-fund industry is one of the most important revelations to have come out of the LTCM debacle. Prior to August 1998, vulnerabilities in the global financial system involved stock market crashes, bank runs, and hyperinflation—otherwise known as “systemic risk”— were largely the province of central bankers and finance ministers. Such events were rare but generally well understood, as in the case of the Asian Crisis of 1997 in which overleveraged financial institutions and weak corporate governance led to a series of currency devaluations, stock market crashes, and defaults in Korea, Thailand, Indonesia, and other Asian countries.

Graveyard funds also seem to exhibit less illiquidity exposure as measured by serial correlation and the MA(2) smoothed-returns model of Getmansky, Lo, and Makarov (2004). Certain investment styles such as Managed Futures and Global Macro are prone to higher attrition rates, presumably because of their higher risk levels, and the recent increase in attrition rates for Long/Short Equity funds is a potential source of concern because of the large number of funds in this category and the amount of assets involved.

A useful summary statistic for measuring the concentration of weights is k θj2 ∈ [0, 1] ξ≡ (4) j=0 This measure is well known in the industrial organization literature as the Herfindahl index, a measure of the concentration of firms in a given industry where θj represents the market share of firm j. Because θj ∈ [0, 1], ξ is also confined to the unit interval, and is minimized when all the θj are identical, which implies a value of 1/(k + 1) for ξ , and is maximized when one coefficient is 1 and the rest are 0, in which case ξ = 1.