Hedge fund closures to fall in 2010?

Much of the research conducted on hedge funds relies on the fidelity of a small number of hedge fund databases that count on the voluntary reporting of returns by the world’s hedge fund managers.  Due to the voluntary nature of these databases, one might be excused for wondering if managers’ decisions to either begin submitting data or to cease submitting data would have a material effect on the reported performance of the hedge fund industry as a whole.

The question of why hedge fund’s stop reporting data has recently come back to the fore with this article in the Fall edition of the Journal of Portfolio Management by Alex Grecu, Burton Malkiel and Atanu Saha.  The idea underpinning the article has been around for a few years and was actually included in a presentation and paper submitted by the authors to the Atlanta Fed in late 2006 (see related posting).   

They find that, like human life expectancy figures, the likelihood of death goes down with age – after a certain point.  In other words, if hedge funds make it past the critical first few years, then they are quite likely to stay alive for the long term.  The chart below shows the lifespan of hedge funds in the widely quoted TASS hedge fund database.  (Note: funds that were still alive by April 2004, the date of the study, were treated as having a “duration” equal to their age by that date).

 

The authors translate this data into a measure of the likelihood of failure of a hedge fund and find that the highest likelihood of failure or “hazard rate” is about 1% per month or 12% per annum probability occurs somewhere in the fund’s sixth year of life.

The very gradual decrease in “hazard rate” after the fifth year stands in contrast to mutual funds which, according to research cited in the paper, experience a pronounced drop-off in hazard rate by year 10.  This, the authors conjecture, is because hedge funds’ high water marks leave even the most seasoned funds vulnerable to closure as their managers simply throw in the towel after a large drawdown. 

In what may not come as a surprise to many, they also find that hedge funds that ceased voluntary reporting tended to have below average returns in the months leading up to the end of their reported data.  In fact, the paper challenges the notion that some hedge funds stop reporting simply because they are “too successful” and therefore don’t want to raise any more capital. 

Interestingly, this suggests that a recent drop-off in new fund launches may actually foreshadow a commensurate fall in failure rate in about 5 years (see chart from recent ECB report below).  It will be interesting to revisit this question in 2010.  So stay tuned. 

 

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