Then, last August, we told you about a paper by John Dai and Suresh Sundaresan of Capula Investment Management called “Risk Management Framework for Hedge Funds: Role of Funding and Redemption Options on Leverage”. In it, Dai and Sundaresan argue that a hedge fund essentially sells an option to each of its investors and lenders (e.g. prime brokers) since both parties are free to pull the plug on their support (although investors often face extensive waiting periods).
Now, a new working paper by Benjamin Klaus and Bronka Rzepkowski of the European Central Bank called “Risk Spillover Among Hedge Funds” combines these two concepts by blaming hedge fund contagion on both investor redemptions and “tightening financial conditions” precipitated by prime brokers.
Being central bankers, the authors also propose several policy prescriptions. So you may want to check out this report if you’re trying to forecast how the Europeans – and potentially the Americans – are going to tackle hedge fund regulation.
The report lays out the case for why the actions of co-investors can impact the behavior of other investors and lead to a “self-fulfilling run” on a fund for no good reason.
Funds in the same strategy class (e.g. convert arb) are impacted by the strategy-wide redemptions and the failure of adjacent funds. But while funds in different hedge fund classes (e.g. market neutral) also suffer when there peers go under, they actually benefit when investors flee funds in different strategy classes. Their failure rate drops when investors bail out of other strategies.
Some may see this as kind of intuitive given hedge fund investors’ propensity to jump horses in the middle of the race. While some funds serve as proverbial “bank machines”, the cash withdrawn from some strategies may be just enough to dampen this trend across other strategies.
“Re-Appraisal of Risk”
While the concern that co-investors might re-appraise their appetite for a particular hedge fund is real, it’s not the only way a fund can succumb to negative externalities. The report also says that select fund failures can lead to a “re-appraisal of risk” than could…
“…prompt prime brokers to tighten financial conditions to existing hedge funds, thereby propagating initial stress within the industry…”
Diversification: A double-edge sword or double protection?
Finance 101 tells us that diversification reduces portfolio risk. But does it also reduce the risk of investors or prime brokers precipitating a disintegration of a hedge fund? In other words, can fund diversification indirectly impact the effect of these externalities?
It turns out that highly diversified hedge funds seem to be protected, to some extent, from a strategy-specific redemption wave. As the authors hypothesize:
“A possible explanation for this finding might be that diversified funds are perceived as being different from the other funds of one specific investment style and thus do not suffer so much from redemptions occurring within funds of one style category.”
So while diversification has long since been understood as a way to mitigate endogenous (portfolio) risks, it’s also apparently a way to mitigate the effects of “self-fulfilling runs” and skittish prime brokers.
Internal factors affecting failures
Of course, many factors within the control of the manager also seem to determine the risk of fund failure. For example, the report finds that you can forecast fund failures by trailing the usual suspects: recent redemptions, a higher incentive fee, use of derivatives and the failure of adjacent funds. On the other hand, inflows, a highwater mark, longer redemption notice periods and longer lock-ups led to a lower risk of failure (see table below – click to enlarge).
The bottom line, according to Klaus and Rzepkowski (our emphasis):
“Based on our results, it seems to be important that hedge funds provide information on size, capital flows, restriction periods, incentive fees and on their investment into derivatives to regulatory authorities. In particular, information on capital flows and on a fund’s restriction periods is important for enabling a regulator to evaluate the funding risk of a hedge fund and thereby its failure probability.”
In other words, you need to know if your hedge fund manager may walk off with your bank machine.