In case you missed it (and we suspect you did unless you make a habit of reading monster 242-page publications like this) the European Central Bank’s December “Financial Stability Review” contains some interesting original analysis on the hedge fund industry. (See pages 46-60 of the report)
Acknowledging the role of hedge funds in August’s turmoil, the report points out that September’s rebound illustrated that “…other hedge funds stepped in to buy assets at bargain prices, thereby providing rather than consuming liquidity.” In fact, the ECB’s own analysis shows that only 5% of single-manager hedge funds invested directly in mortgage-backed securities and that YTD returns are tracking to historical norms (chart – right)
Nevertheless, continues the report, a “vicious circle could set in, whereby forced liquidations cause losses, margin calls from counterparties and investor redemptions, leading to even more asset sales.” And if high yield bonds and credit derivatives are added to the mix, then 20% of global hedge funds assets “could be affected by the recent turbulence.”
(Note that the chart at the right also shows the lack of return persistence in hedge funds. As the year progress, big year-one winners can’t seem to repeat. Thankfully, nor can big year-one losers.)
This all leads to the $4 trillion question of how “crowded” were the hedge fund trades that allegedly all had to be unwound at once in August. Since actual hedge fund holdings can’t be compared very easily, the authors of the report analyze the correlation between the returns of hedge funds using the same strategies. (Note: some of the mega-prime-brokers track the most popular hedge fund trades to measure the level of “crowding”. More on that later in the week).
“Within most strategies, median pairwise correlations have been declining since the beginning of 2007 suggesting lower risks, but they increased in the summer, in some cases, quite markedly. Fixed income arbitrage, multi-strategy and event-driven strategies also all recorded such increases, suggesting that there were some similarities in the positioning across hedge funds within these strategies.”
The problem with measuring the average correlation between hedge funds is that the correlation coefficient can go up simply because volatility goes down. The report cites a previous article on the topic by the New York Fed (see related posting) and undertakes its own analysis of the influence of co-movement and volatility on the commonly-cited “correlation” figure (click on Chart 3c at right).
“…the correlation coefficient can increase solely as a result of lower volatilities of returns, rather than because of their higher covariance. For example, during the last five quarters to June 2007, the contribution of lower volatilities to the moving 12-month weighted average pairwise correlation coefficient across hedge fund strategies was always positive, whereas the contribution of covariances was always negative or close to zero…”
In an effort to determine the effect of hedge funds on “financial stability”, the report also examines leverage. The findings are interesting, although not surprising. The appetite for leverage ranges greatly between the high-leverage strategies (global macro, managed futures) and the rest (chart 1.40 – left).
Some theorized that single managers also faced a problem in August from ailing funds of funds all making redemption requests at the same time. The report lends some credence to this argument, pointing out that funds of funds’ control over hedge fund industry assets was skirting all-time highs for the past year. Compounding this, continues the report, was the fact that many of these funds of funds were leveraged – adding the urgency of their redemptions once they faced margin calls or redemption requests from their own investors.
In fact, the so-called “liquidity mismatch” between funds of funds and underlying single-manager funds is clearly illustrated in Chart A (right) which shows recently falling lock-ups for funds of funds and recently rising lock-ups for single managers.
Finally, and in contrast to many media reports, the ECB finds “no hard evidence that liquidations of single-manager hedge funds had risen significantly in 2007.” (see chart 1.45 left).