New ECB Model Aims to Predict HF Liquidations

16 Jun 2009

A lot of the hedge fund research we review each day on is produced by academics.  But occasionally, we come across some very interesting tidbits from regulators and central banks.  The ECB’s semi-annual Financial Stability Review (FSR) is one such example (see previous posts).

In keeping with previous reports, the new 1H 09 ECB FSR is A-OK.  As usual, it provides an update on industry leverage, cross-correlation and industry attrition.  The chart below right from the report the industry’s annual launch and closure rates (click to enlarge).

Obviously, the past year has been rough on the hedge fund business.  But what exact are the factors that lead to such an increase in hedge fund liquidations (red) and attrition (green)?  This edition also contains an interesting “Special Feature” on estimating the probability of hedge fund liquidations (downloadable separately here).

As you might guess, the specter of hedge fund liquidations is never far from the thoughts of a financial regulator.  As the report points out:

“A failure of an individual hedge fund or a group of hedge funds can have adverse implications for financial stability, mainly through an impact on asset prices and market liquidity and through potential losses for the hedge funds’ creditors. Therefore, it is important to understand the underlying reasons behind hedge fund failures and to create indicators that would allow strains in the hedge fund sector to be monitored.”

“Half Dead”

The first step in the process of predicting attrition in the hedge fund industry is to identify all funds that are “dead”.  These funds are routinely listed in the “graveyard database” maintained by most database vendors.  Amazingly, over half of all hedge funds that have ever existed are now “dead”.  The chart below shows that a fifth of all hedge funds that have ever existed are now liquidated and nearly a third have simply gone AWOL.

After filtering out superfluous data such as parri passu offshore versions of existing onshore funds, the ECB regressed the liquidated funds against over 50 variables ranging from fees to redemption terms to strategy performance.  This list was then whittled down to 15 variables that are statistically significant predictors of the impending liquidation of a hedge fund.  We have assembled those variables into the table below (click to enlarge):

The accuracy of the resulting predictive model is pretty good (see Page 165 of the report for details).

The good news is that it appears the risk of single manager hedge fund liquidations may have peaked in late 2008 and is now down at levels that are quite common over the past decade as the chart below from the report shows:

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