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1 May 2013 CFA Institute Journal Review

Are Hedge Funds Systemically Important? (Digest Summary)

  1. Nicholas Tan, CFA

The authors find that hedge funds during the 2008 financial crisis did not systematically benefit from opportunistic trading, which could have generated systemic risks in financial markets. Although some funds that used leverage actually performed worse than expected given ex ante risk-factor loadings, this result was most likely caused by meeting redemptions rather than by forced selling during the crisis.

What’s Inside?

Disruptions in capital markets during the 2008 financial crisis were blamed on destabilizing actions by various types of investors, including hedge funds. The authors analyze hedge fund returns during the financial crisis and determine the role they may have played. If hedge funds had traded at the expense of the rest of the market, then they should have exhibited superior risk-adjusted returns. Likewise, if forced selling by hedge funds had driven down prices of assets, then those funds should have exhibited abnormally poor risk-adjusted returns.

How Is This Research Useful to Practitioners?

The authors find no evidence of widespread opportunistic trading by hedge funds during the 2008 crisis. Some literature has suggested that traders can profit from opportunistic trading that manipulates stock prices. They look at funds that are most likely to have the ability and expertise to conduct such trades (short bias, long–short equity, and market-neutral funds) and find that hedge fund returns during the financial crisis were, on average, subpar. The authors find that although hedge funds experienced significantly negative returns during the crisis, the risk-adjusted returns were also unusually poor, and the bad relative performance was concentrated among a small number of funds. Funds that used high levels of leverage are found to have had abnormally low returns as well. Thus, it does not appear that hedge funds as a whole had a large causal role in the financial crisis.

Hedge funds that used leverage and were thus most likely to be forced to liquidate positions in bear markets were found to have actually performed better compared with firms that did not use leverage. The separation of funds by use of leverage did not provide evidence that leveraged funds were more susceptible to forced deleveraging and portfolio liquidation at fire-sale prices. This finding suggests that hedge fund selling was more likely caused by a need to meet redemptions rather than by forced selling into a falling market, which would generate systemic risks.

The authors also comment on the new financial regulation framework enacted in the United States in July 2010 that requires hedge funds to increase transparency in reporting certain areas, such as assets under management (AUM), trading positions and practices, leverage, and risk exposure measurements. This regulation framework should provide a mechanism for determining systemic risks by hedge funds. But the authors believe that more reporting and transparency may not be effective in limiting the systemic risks because, based on their findings, it is probably just a small number of funds with difficult-to-identify characteristics that pose systemic risks.

How Did the Authors Conduct This Research?

The data on hedge funds come from Lipper TASS, Hedge Fund Research, Bloomberg active and inactive hedge fund databases, and proprietary information on 297 funds from a large hedge fund of funds. The sample contained data for 17,127 unique funds and a sample period covering January 2002 through December 2008. The authors estimate that the sample includes most of the funds with at least $50 million in AUM and about 85% of total industry AUM.

Two main tests were conducted on the aggregate dataset. First, the authors undertake time-series tests that estimate historical risk-factor loadings for hedge funds and then use those results to estimate abnormal returns for each of the months during the financial crisis from July through December 2008. The risk-factor loadings are estimated using ordinary least squares over 60-month rolling windows, ending in June through November 2008. Second, the authors conduct panel regressions over shorter time horizons to identify any short-run changes in factor loadings and abnormal returns during the crisis. Funds with leverage and high ex ante risk were then separately analyzed to determine whether those funds were differentially affected by deleveraging.

Abstractor’s Viewpoint

Hedge funds are private entities and have fewer public disclosure requirements than other financial institutions. Investors, such as institutional investors, could use their clout to encourage hedge funds to increase transparency in disclosing information, such as AUM and trading metrics, as part of their requirements when investing. This push from investors, coupled with regulators’ requirements, would help the general public better identify the risks posed by hedge funds, especially the systemic varieties that affect an economy’s well-being.

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