The European Central Bank published it’s semi-annual “Financial Stability Review” last week and as usual, it contains some interesting observations about the hedge fund industry.
Cautious attitudes of hedge funds “detrimental to the functioning of financial markets”
Some hedge fund critics point to hedge fund “deleveraging” and hedge fund “selling” as enablers, if not the cause, of the recent market downturn. Although selling off a market neutral portfolio has a net zero impact on markets, many hedge funds are long-bias and therefore it could still be argued that they put downward pressure on prices. But the corollary of the hedge fund induced market crash is that hedge funds must have also been the ones supporting the market in the good time. The December ECB report notes that hedge fund redemptions are therefore bad for markets:
“The reduced availability of leverage notwithstanding, such cautious attitudes of hedge fund managers, even if probably justified at a fund level, are detrimental to the functioning of financial markets, since they imply asset sales and deprive markets of their most active participants.”
Reduced hedge fund leverage
Whether it was self-induced or was thrust upon it, there seems to me little question that overall hedge fund leverage has been falling for quite come time. The two charts below from the CB report show how gross exposure (of long/short funds) and overall leverage (of all funds) have both fallen over the past 18 months. (click to enlarge)…
Not the first time that really terrible performance has plagued the laggards
The report points out that while there have been plenty of hedge fund disasters (e.g. 50% drawdowns), the proportion of funds with returns in that range is about the same as the proportion in that range in 1999. In fact, the worst 10% of funds this year has only performed a little poorer than the worst 10% of funds during the entire 1999-2003 period (left chart – click to enlarge). The difference this time is that the mean fund (solid blue line) is way down below its 1999 lows.
Using a lack of reporting as an indicator of attrition, the ECB makes a startling observation in the right hand chart above. While launches are way off, actually “liquidations” are actually below their long term average rates. However, the proportion of funds experiencing some other form of “attrition” is way way up. As a result, the 12 month moving sum of net new funds dipped into negative territory in mid-2007. Since a disproportionate amount of hedge funds are below average size, we expect the red line to stay below zero for a year or two.
In the end, the ECB seems to concur with the Economist, which wrote in an October article that the challenge facing hedge funds isn’t deleveraging, but redemptions.
“…in the period ahead, the main challenges faced by most hedge funds will be investment performance results and the retention of dissatisfied investors. Since leverage levels did not appear to be high, the likelihood of further deleveraging is rather low. However, further sizeable position unwindings by hedge funds due to probable higher investor redemptions and more frequent cases of hedge fund liquidation may pose a challenge to financial markets.”