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Vol. 2, No. 8
AUGUST 2007
EconomicLetter
Insights from the
Federal Reserve Bank of Dall as
Hedge Fund Investors More Rational Than Rash
by Jeffery W. Gunther and Anna Zhang
The banking industry’s treatment of loans has undergone a dramatic
Hedge funds
transformation over the past two decades. While maintaining their traditional
have become
role in originating loans and holding them on their books, banks have become
increasingly important
more likely to create and sell securities backed by pools of loans and other debt
in financing the
instruments.
originate-to-distribute
Banks’ adoption of the “originate-to-distribute” model has been ac-
banking model.
companied by equally dramatic changes in risk management.1 When banks sell
these asset-backed securities to institutional investors, they disperse risks outside
the banking system. Banks also provide tools to address the risks of loans and
asset-backed securities through derivative instruments, such as interest-rate and
credit-default swaps. These changes not only enhance banks’ and investors’ ability to manage risk but also increase the availability of credit to businesses and
individuals.
Integral to this process are
hedge funds—largely unregulated,
leveraged investment vehicles that,
unlike mutual funds, freely employ
complex and flexible trading strategies. As one of the most dynamic
forces among institutional investors,
they’ve become increasingly important
in financing the originate-to-distribute
banking model.
The shift in banking strategy and
the rise of hedge funds have led to
a financial system increasingly based
on the pricing and trading of complex
credit-related instruments. As a result,
investor and market behavior play a
greater role in overall financial steadiness. Hedge funds can contribute to
stability when they provide liquidity to
financial markets, particularly for risky
assets. In times of financial stress, the
funds can undermine stability if their
own health comes into question, triggering rapid withdrawals.
The roles of banks and institutional investors had evolved over the past
few years under generally favorable
conditions, without the stresses that
accompany financial turbulence.2 But
this year, troubles in the home mortgage market have meant steep losses
and closures at some hedge funds.
The situation has revealed some of the
risks inherent in hedge funds and the
originate-to-distribute model.
Hedge funds’ potential to roil
financial markets makes headlines.
Examining funds’ performance and
money flows over a decade, however,
provides a more balanced view of
their overall role in financial stability.
Except in especially adverse
circumstances, we find hedge fund
investors tend to focus on longerterm rather than immediate performance. In addition, they often
stick with successful fund managers
through a downturn. Such behavior
adds stability to hedge funds’ financial bases and limits capital flight.
increasingly popular in recent years
as institutional investors turned to
them as vehicles for pursuing outsized
returns.3 Industry estimates suggest
hedge funds account for more than
half the trading volume in distressed
debt, emerging market bonds and
credit derivatives and about a third of
all U.S. equity trading.
Hedge funds’ growing prominence belies a checkered past that
includes a well-publicized episode
involving Long-Term Capital
Management (LTCM). In early 1998,
the hedge fund bet that yields on
high-risk bonds would fall relative to
Source of Liquidity
Hedge funds have operated for
a long time, but they’ve become
EconomicLetter
low-risk bonds. This proved wrong,
and Russia’s devaluation and debt
default that August multiplied the
fund’s losses.
With financial markets already
fragile, the possibility that LTCM’s collapse might spill over to large banks
and securities firms led to a rescue
by a creditor consortium.4 Although
major troubles were averted, the LTCM
episode illustrates the potential risks
hedge funds pose to overall financial
system stability.
Hedge funds, however, aren’t just
sources of added risk. They benefit
financial markets by determining asset
Hedge Funds: A Balance Sheet
Benefits
Price discovery — By seeking arbitrage opportunities associated with
misaligned prices and exploiting them through short sales, derivatives
and other leveraged trading strategies, hedge funds promote price discovery, resulting in more efficient markets and lower capital costs.
Risk dispersion — As counterparties to derivative and securitization
transactions, hedge funds help banks disperse risk and foster innovation
in risk-management tools and techniques.
Investor diversification — Because hedge funds often focus on arbitrage opportunities, they tend to be market neutral, offering investors an
attractive means of diversification.
Market liquidity — Hedge funds are significant providers of liquidity to
the financial market, especially the riskiest and most vulnerable segments. In providing such liquidity, funds can help stabilize markets when
disturbances strike.
Risks
Price volatility — Innovations in financial products, such as complex
derivatives and structured products, have expanded the ways hedge
funds apply leverage. A concentration among hedge funds of similar
market positions and high leverage could lead to extreme price volatility
if traders unwind their positions at the same time.
Market illiquidity — Pervasive losses on similar positions could lead
many hedge funds to retrench simultaneously, leading to market illiquidity and credit contraction.
Loss spillovers — Hedge fund problems typically don’t pose risks to
the financial system. But there remains the potential for a major fund’s
losses or failure to trigger a broad dislocation that would damage the
system enough to adversely affect overall economic activity.
Hidden losses — Some of the complex and often illiquid financial products hedge funds have helped foster are difficult to value, raising concern that potential losses might remain hidden for a considerable time
and lead to market uncertainty and unpleasant surprises for investors.
Federal Reserve Bank of Dall as
prices, dispersing risk and fostering
diversification (see “Hedge Funds: A
Balance Sheet”). Perhaps most important, funds’ routine activities contribute to financial stability by providing
liquidity for the originate-to-distribute
banking model.
In pursuing this strategy, banks
bundle debt instruments into pools,
which provide the projected income
streams that serve as the basis for
new securities. These securities are
structured with the safest segment,
or tranche, at the top, with an investment-grade rating. It incurs losses
only if bad debts have already eaten
through all the lower tranches.
Because of their desire for higher
yields, hedge funds often invest in
the riskier tranches—assets designated to absorb the first or second
level of losses. In doing so, hedge
funds supply the liquidity needed
to support the higher tranches of
investment-grade securities sought by
other institutional investors. By selling insurance in credit-default swaps,
they also help provide protection for
other institutional investors and banks
themselves.
Because of hedge funds’ growing significance as a source of market
liquidity, their health and stability have
become key issues for the overall
financial system.
Money Flows
Hedge funds run into trouble
when investment strains mean they
can’t maintain a stable funding base.
Investors’ attempts to withdraw their
funds after a period of poor performance often force funds to contract,
sometimes necessitating distress sales
of assets. In extreme circumstances,
funds are forced to shut down.5
Hedge funds are well aware of
the need to maintain liquidity, and
they impose restrictions to reduce the
likelihood and magnitude of capital
outflows (see “Stability-Enhancing
Restrictions”). These measures may
help solidify a hedge fund’s capital
base, but they can be overwhelmed
Stability-Enhancing Restrictions
Minimum Investment
Hedge funds typically require a minimum investment, sometimes $1
million or more. The restriction usually limits participants to relatively
sophisticated investors who would conduct considerable due diligence
before investing and be unlikely to withdraw their funds on a whim.
Hedge funds’ limited accessibility has been one of the primary arguments against the need for regulation and investor protections.
Lockups
Most hedge funds impose “lockup” periods, during which investments
can’t be redeemed. While lockups typically last from six months to two
years, some funds have secured five- or even 10-year periods. Lockups
enable hedge funds to reduce the need for liquid assets while shifting
investment strategies into more exotic and less liquid arenas. For investors desperate to leave hedge funds under lockup, secondary markets
have sometimes provided an escape.
Redemption Periods and Gates
The illiquid nature of many hedge fund investment strategies often
makes the immediate satisfaction of redemption requests difficult.
Hedge funds typically require a one- to two-month redemption notice.
Fund managers can often extend notice periods, allowing greater flexibility in managing a large number of redemption requests. Fund managers
also have the ability to invoke “gates” that restrict how much money can
be withdrawn in a given period.
Side-Pocket Accounts
Hedge funds sometimes place especially illiquid assets in side-pocket
accounts. One reason is that the funds can require that investors leave
part of their money in these accounts as a condition for redemption,
ensuring continued funding of these assets.
by adverse money flows, especially in
the face of marked reversals in performance. So the issue of money-flow
stability looms large.
Economic theory tells us that
investors should respond to the riskadjusted performance of individual
hedge funds, an indicator of fund
managers’ skill levels.6 In a rational
market, hedge funds with the most
successful leadership should receive
greater money inflows.
One measure of risk-adjusted
performance is “alpha,” the part of
a hedge fund’s return above the
risk-free rate that can’t be explained
by exposure to underlying market
movements.7 The Sharpe ratio, a
related measure, captures a fund’s
risk–return profile, taking into account
Federal Reserve Bank of Dall as
Hedge funds run
into trouble when
investment strains
mean they can’t
maintain a stable
funding base.
EconomicLetter
The correlation of
money flows with
longer-term
performance points
to an important
source of stability for
individual hedge
funds and the
industry as a whole.
both profitability and underlying volatility.
If capital providers respond to
indicators closely related to managers’ skills, short-run ups and downs in
profits may not necessarily precipitate
injections or withdrawals.
Similarly, investors who focus on
longer-term prospects associated with
managers’ skills may not necessarily
retract their money when performance
falters as part of a general decline
among funds operating in a particular
strategy, or market segment. Such a
broad-based decline could reflect temporary market setbacks; if so, it may
not represent an indictment of managers’ ability over the longer term.
Does the historical pattern of
hedge fund money flows bear out
these implications?
Short- Versus Long-Term
Performance. Over the past 10 years,
the hedge fund industry has experienced substantial swings in monthly
profitability (Chart 1).8 The low point
during this period occurred in August
1998, the month of the Russian debt
default.
Over longer stretches, monthly
volatility averages out, making the
industry’s profitability over a rolling
12-month period much more stable.
It turned negative only once in the
decade—in September 1998, with the
Russian situation again the culprit.
Now, let’s look at net monthly
money flows, defined as capital contributions less withdrawals.9 They’re considerably less variable than monthly
profits, exhibiting a relatively subdued
pattern closely related to 12-month
profitability.
The money flow pattern suggests
capital providers aren’t heavily swayed
by monthly gyrations in profitability.
Instead, money flows are more
strongly associated with funds’ longerterm performance, which should more
closely reflect the skills of hedge fund
managers.
This correlation of money flows
with longer-term performance points
to an important source of stability for
individual hedge funds and the industry as a whole.
Absolute Versus Relative
Performance. Hedge fund investors
won’t necessarily retract their money
in the face of a downturn affecting
Chart 1
Money Flows Track Longer-Term Profitability
Percent
8
6
4
2
0
–2
Average rate of capital contributions less withdrawals
–4
–6
Average profitability in current month
Average profitability over last 12 months
1997
1998
1999
2000
2001
SOURCE: Authors’ calculations using Lipper TASS database.
EconomicLetter
Federal Reserve Bank of Dall as
2002
2003
2004
2005
2006
an entire industry segment, especially
when their funds perform well relative
to others pursuing the same strategy.
Investors’ willingness to take into
account relative performance provides
an additional source of stability in
hedge fund liquidity.
One commonly used breakdown identifies 11 major hedge fund
business models (see “Hedge Fund
Strategies”). The groups can serve
as proxies for the markets in which
hedge funds compete. For example,
all funds following an equity-market
neutral strategy attempt to create portfolios uncorrelated with overall market
movements, and they compete directly
with each other to provide this investment service.
Firms pursuing some of these
strategies have encountered difficult
operating environments at some point
over the past 10 years.
When it comes to 12-month profitability, the 11 strategies, calculated
separately, show a much wider range
of performance than the hedge fund
industry as a whole (Chart 2). Losses
occurred about 10 percent of the time
at the strategy level but in only one
period for the industry.
Money flows during times of
stress in a particular strategy should
provide additional insight into hedge
fund stability. To conduct the analysis,
we divided the 10-year sample’s data
on individual funds into five groups
based on absolute performance, or
Chart 2
Profits Vary More
at Strategy Level
(Average 12-month profitability)
Percent
6
4
2
0
Hedge fund industry as a whole
–2
Individual hedge fund strategies
–4
–6
Lowest
Hedge Fund Strategies
Rank
Highest
SOURCE: Authors’ calculations using Lipper
TASS database.
Convertible arbitrage — Exploits mispricing of convertible bonds. The
strategy typically is long on a corporation’s convertible bonds and short
on its common stock.
Dedicated short bias — Holds a portfolio heavily weighted with short
positions. Returns tend to be highly volatile.
Emerging markets — Invests in fixed income and equity in emerging
markets, which often have high inflation and volatile growth. Effective
hedging is often difficult.
Equity-market neutral — Balances long and short positions to achieve
minimal market exposure. Returns tend to exhibit low volatility and little
correlation with equity markets.
Event-driven — Includes distressed securities, merger arbitrage and
other styles that focus on returns from a particular event.
Fixed-income arbitrage — Exploits relative values of government bonds,
corporate bonds, government agency securities, swap contracts, and
futures and options on fixed-income instruments.
Global macro —Exploits divergences between and within currencies,
bonds, equities and commodities. Investment decisions are based
largely on macro, or top-down, views of large-scale trends.
Investors’ willingness
to take into account
relative performance
provides an additional
source of stability in
hedge fund liquidity.
Long/short equity—Holds long and short equity positions. Investment
decisions typically are based on bottom-up stock analysis but may
include top-down macro-based factors.
Managed futures —Holds long and short positions in liquid commodity or financial futures, such as oil, currencies, interest rates and stock
market indexes. Investment decisions are based on quantitative, trendfollowing models.
Multistrategy —Follows a diversified approach that employs various
strategies to capitalize on short- and long-term opportunities.
Fund of funds —Holds a portfolio of hedge funds to diversify strategies
and asset classes.
Federal Reserve Bank of Dall as
EconomicLetter
Chart 3
Within Markets, Absolute and Relative Profitability
Rise Together
(Average 12-month profitability for each intersection of absolute and market
performance)
Percent
4
Average market-level profitability
Average fund deviation from market-level profitability
3
2
1
0
{
{
{
{
{
–1
Worst markets
–2
Second-worst markets
Average markets
Second-best markets
Best markets
Absolute (fund-level) profitability
Lowest
Middle
Second lowest
Second highest
Highest
SOURCE: Authors’ calculations using Lipper TASS database.
Chart 4
Money Flows Rise with Absolute and Relative
Profitability
(Average monthly capital contributions less withdrawals for each intersection
of absolute and market performance)
Percent
4.5
3.5
2.5
1.5
.5
–.5
–1.5
{
{
{
{
{
–2.5
Worst markets
–3.5
Second-worst markets
Average markets
Second-best markets
Best markets
Absolute (fund-level) profitability
Lowest
Second lowest
Middle
Second highest
Highest
SOURCE: Authors’ calculations using Lipper TASS database.
EconomicLetter
Federal Reserve Bank of Dall as
each hedge fund’s 12-month profitability.10 We also constructed five groups
based on market conditions, or the
median level of 12-month profitability
for the strategy within which a hedge
fund operates.11
These two groupings neatly characterize hedge funds’ absolute performance, market conditions and performance relative to peers in the same
strategy (Chart 3).12 By definition,
strategy-level profitability increases
with the move from worst to best market conditions (red line). Within each
of the five market conditions, funds
vary on both absolute profitability
(bar height) and relative profitability
(striped sections).
A hedge fund that’s among those
facing the worst market conditions
but in the group for top absolute performance (far right bar within far left
bracket) has performed very well relative to its peers.13 Conversely, a hedge
fund encountering the best market
conditions but falling into the bottom absolute-performance group (far
left bar within far right bracket) has
performed very poorly relative to its
peers.14
How do net money flows
respond to these varying levels of
absolute and relative performance?
Within each of the five market-conditions groups, we see a strong tendency for money flows to rise along
with absolute performance (Chart
4). Note, however, that these rising
money flows within market-conditions groups involve increases in two
quantities—absolute performance and,
perhaps more important, performance
relative to peers.
An interesting pattern emerges in
average money flows for some absolute-performance groups as we move
across varying market conditions.
For the second-lowest, middle and
second-highest absolute-performance
groups, money flows tend to decline
as market conditions improve. Looking
at the middle absolute-performance
group (bright blue bars), for example,
investors reward this performance
level with greater capital inflows in the
worst markets (far left) than in the best
markets (far right). Most likely, this
occurs because when holding absolute
profitability constant, improving market
conditions imply declining fund-level
profitability relative to others following
the same strategy.
For the middle three absoluteperformance groups, the patterns
reveal a positive association between
money flows and superior returns
relative to similar funds. However, for
some absolute-performance groups,
most notably the bottom and top, the
absolute level of performance itself
appears to dominate, with little apparent association between money flows
and performance relative to peers in
the same market.
Similar patterns emerge using the
Sharpe ratio as a measure of managers’
skills. This risk-adjusted metric is based
on the ratio of average profits over the
most recent 12 months to the standard
deviation of monthly profits.15
Once again, for the three midrange performance groups, an association exists between money flows
and performance relative to those in
the same market (Chart 5). Greater
net inflows reward superior returns
relative to other funds following the
same strategy.
These findings confirm that investors have tended to provide additional
capital to hedge funds that outperform competitors in their category.
The positive association between
managers’ skill and money flows
enhances the stability of hedge fund
liquidity because an individual fund’s
profitability tends to elicit larger
money flows in a down market than
in an up one. When a hedge fund’s
performance declines during a market
segment downturn, capital providers
tend to cut back to a lesser extent
than when a fund’s performance
declines in both absolute and relative
terms, creating an additional source
of stability in hedge fund liquidity.
Chart 5
Money Flows Rise with Absolute and Relative
Profitability—Sharpe Ratio
(Average monthly capital contributions less withdrawals for each intersection of
absolute and market performance)
Money flow data indicate these
beneficial dynamics have limits.
Capital flight tends to occur once
funds’ longer-term performance sinks
in absolute terms, irrespective of relative performance. This pattern suggests that sustained deterioration in
fund performance, or even strong
signals pointing in that direction, will
lead to capital outflows. We’ve seen
this scenario play out recently for
hedge funds entangled in mortgage
losses.
More Rational Than Rash
The data on hedge fund performance and money flows reveal factors
that enhance stability. Longer-term
performance matters for hedge fund
money flows, apparently more than
short-run gyrations in returns. Money
flows also suggest that investors are
attracted substantially by hedge funds’
performance relative to others following the same strategy, providing
a cushion for funds that do relatively
well in a falling market.
We must never forget, however,
that especially adverse performance
can lead to more abrupt capital outflows. All told, the links between
hedge funds’ performance and money
flows point to both the sources and
limits of stability in today’s financial
system.
Gunther is an assistant vice president in the
Financial Industry Studies Department of the
Federal Reserve Bank of Dallas. Zhang is a student at Harvard University and was a summer
intern in the department.
Percent
4.5
3.5
2.5
Notes
1.5
1
.5
stability, see “Risk Management and Financial
–.5
Stability—Basel II and Beyond,” remarks by
–1.5
Nout Wellink, president of the Netherlands Bank
{
{
{
{
{
–2.5
–3.5
For a high-level overview of challenges posed
by the originate-to-distribute model for financial
Worst markets
Second-worst markets
Average markets
Second-best markets
Best markets
Absolute (fund-level) profitability
Lowest
Second lowest
Middle
Second highest
Highest
SOURCE: Authors’ calculations using Lipper TASS database.
and chairman of the Basel Committee on Banking
Supervision, to the Global Association of Risk
Professionals’ 8th Annual Risk Management
Convention and Exhibition, New York, Feb. 27,
2007 (www.bis.org/review/r070228a.pdf). For an
Federal Reserve Bank of Dall as
EconomicLetter
EconomicLetter
overview of challenges financial markets pose for
denote months. Values below the 1st or above
banks and financial stability, see “The Risks of
the 99th percentile are set to those boundaries.
Financial Institutions,” by Mark Carey and René
We tried a similar adjustment for profitability,
M. Stulz, National Bureau of Economic Research
which didn’t materially affect the results.
Working Paper no. 11442, June 2005 (www.nber.
10
org/papers/w11442.pdf).
a hedge fund’s profitability. The bottom one
2
Like policymakers, researchers have also
The absolute-performance groups measure
consists of the lowest 20 percent of observations
expressed concern about the rapid growth in the
based on rolling 12-month returns, or the bottom
prominence of institutional investors, particularly
performers. The middle three groups include
hedge funds. See “Systemic Risk and Hedge
the next 60 percent of monthly observations,
Funds,” by Nicholas Chan, Mila Getmansky,
ranked from low to high profitability. The top
Shane M. Haas and Andrew W. Lo, National
group contains the highest 20 percent, or the top
Bureau of Economic Research Working Paper
performers.
no. 11200, March 2005 (www.nber.org/papers/
11
w11200).
level of profitability prevailing in a hedge fund’s
3
For a comparison of hedge funds and mutual
The market-conditions groups measure the
strategy. The bottom group in this second
funds, see “Hedge Funds: Past, Present, and
ranking consists of the lowest 20 percent of
Future,” by René M. Stulz, Journal of Economic
observations based on the median 12-month
Perspectives, vol. 21, Spring 2007, pp. 175–94.
returns prevailing in a hedge fund’s strategy.
4
See “Hedge Funds and the Collapse of Long-
This bottom group represents the worst market
Term Capital Management,” by Franklin R.
conditions. Market performance improves with
Edwards, Journal of Economic Perspectives,
each group of 20 percent, with the final group
vol. 13, Spring 1999, pp. 189–210. The Federal
representing the best, or most favorable, market
Reserve played a role in bringing the parties
conditions.
together.
12
5
Often, it’s also the banks from which hedge
For each category of absolute performance,
profitability tends to remain the same across
funds have borrowed that seek to withdraw
the five groups measuring market performance.
funding, which can force the sale of hedge fund
Hedge funds in the second-highest absolute-
assets when market prices are low.
performance group, for example, earned average
For a mathematical demonstration of the idea
monthly returns of about 1.25 percent, regardless
that money flows respond to past risk-adjusted
of whether they operated under the worst market
performance, as an indicator of skill levels
conditions (the bottom 20 percent) or the best
across hedge fund managers, see “Mutual Fund
market conditions (the top 20 percent). In this
Flows and Performance in Rational Markets,” by
way, the intersection of the two groupings holds
Jonathan B. Berk and Richard C. Green, Journal
individual fund performance constant across
of Political Economy, vol. 112, December 2004,
varying market conditions.
pp.1269–95.
13
6
7
For evidence of the empirical linkage between
Some analysts find some degree of persistence
in a type of relative alpha when they evaluate
alpha and capital inflows at hedge funds, see
relative performance with respect to other hedge
“Hedge Funds: Performance, Risk and Capital
funds following similar investment strategies.
Formation,” July 19, 2006, by William Fung,
See “Do Hot Hands Exist Among Hedge Fund
David A. Hsieh, Narayan Y. Naik and Tarun
Managers? An Empirical Evaluation,” by Ravi
Ramadorai, American Finance Association
Jagannathan, Alexey Malakhov and Dmitry
2007 Chicago Meetings paper (http://ssrn.com/
Novikov, National Bureau of Economic Research
abstract=778124).
Working Paper no. 12015, February 2006 (www.
8
The figures are based on 207,035 monthly
14
obtained from the Lipper TASS database.
performance are overrepresented in the worst
The formula for net inflows at an individual
Richard W. Fisher
President and Chief Executive Officer
Helen E. Holcomb
First Vice President and Chief Operating Officer
Harvey Rosenblum
Executive Vice President and Director of Research
W. Michael Cox
Senior Vice President and Chief Economist
Robert D. Hankins
Senior Vice President, Banking Supervision
Executive Editor
W. Michael Cox
Editor
Richard Alm
Associate Editor
Monica Reeves
Graphic Designer
Ellah Piña
nber.org/papers/w12015).
observations involving 5,180 hedge funds,
9
is published monthly
by the Federal Reserve Bank of Dallas. The views
expressed are those of the authors and should not be
attributed to the Federal Reserve Bank of Dallas or the
Federal Reserve System.
Articles may be reprinted on the condition that
the source is credited and a copy is provided to the
Research Department of the Federal Reserve Bank of
Dallas.
Economic Letter is available free of charge
by writing the Public Affairs Department, Federal
Reserve Bank of Dallas, P.O. Box 655906, Dallas, TX
75265-5906; by fax at 214-922-5268; or by telephone
at 214-922-5254. This publication is available on the
Dallas Fed web site, www.dallasfed.org.
Of course, the lower groups based on absolute
markets, while the higher absolute-performance
hedge fund is It = [AUMt − AUMt−1(1+Rt)]/AUMt–1,
groups are overrepresented in the best markets.
where AUM refers to assets under management,
15
R is the hedge fund’s return, and subscripts
three-month Treasury bill yield.
These returns were calculated relative to the
Federal Reserve Bank of Dallas
2200 N. Pearl St.
Dallas, TX 75201
@FedFRASER