Disorderly Exits From Crowded Trades?

A reply to the ECB's statement on hedge funds

EDHEC

An article in the June 2006 edition of the European Central Bank's Financial Stability Review (FSR) claims that hedge fund activities pose considerable risk to the financial system. We disagree with this conclusion, which is based on mere speculation. This article outlines the fallacies in the reasoning of the FSR article and makes some propositions on how to assess the welfare impacts of hedge funds. In particular, we argue that it would be worthwhile for financial regulators to work towards obtaining data on hedge fund leverage and counterparty credit risk. Such data would allow a reliable assessment of the question of systemic risk. In addition, we argue that besides evaluating potential systemic risk, it should be recognised that hedge funds play an important role as "providers of liquidity and diversification".
 

1. The FSR's fallacy

The conclusion in the FSR article is based on the following observations:

i) The article argues that the returns of different hedge fund strategies have become more correlated over time. Likewise, correlations between individual hedge funds classified in the same strategy have increased. This is interpreted as evidence of similar trades across different funds.

ii) According to the article, hedge funds are investing in increasingly illiquid positions. This asset illiquidity exposes them to the risk of sudden redemptions from investors leading to a forced sell-off of illiquid assets.

iii) Finally, the article shows that in certain market conditions (poor fund returns, increasingrisk aversion, increasing interest rates), high investor redemptions are to be expected.

The article concludes that given these observations, there is a risk of "adverse effects of disorderly exits from crowded trades". However, these three observations can be contested, as detailed below.

The increasing correlation is derivedusing a correlation coefficient based on 12 monthly observations. With such a small sample, it becomes impossible to draw reliable inference. In addition, the increasing correlation of returns of single hedge funds in the same strategy is based on comparing data for 2004 with datafor 2005. Just by way of random influences, it becomes quite likely to observe fluctuations between the two years, even if the true economic mechanism has remained constant. In other words, the results are indistinguishable from statistical noise. It should also be noted that the correlation actually decreases for four out of 11 strategies. It is unclear why the article interprets this result as "the fact that correlations are trending higher".

Furthermore, an increasing correlation between funds in the same strategy is by no means equivalent to similar positions. The academic literature interprets high correlation across funds in the same strategy as evidence of similar risk factor exposure. This risk factor exposure may well be obtained by holding different positions. This can be shown by taking the example of volatility risk exposure. Exposure to volatility risk may be obtained by trading index straddles, trading straddles on individual stock options, delta neutral trading in stocks or in the index, or trading volatility futures and options or even by holding stocks that have a high exposure to changes in market volatility.

An increasing correlation does not necessarily mean that the risk factor exposure is increasingly similar across strategies. It may simply be the case that the correlation between risk factors themselves is increasing. Take the example of two hedge funds, one is exposed only to volatility risk (short position in volatility), one is exposed only to stock market risk (long position in the stock market). If volatility has a tendency to increase when stock markets decline (and vice versa), then the two funds will have a high correlation. This has nothing to do with similar positions. In fact, there is zero overlap in the positions of these hypothetical funds.

In addition, the exposure of hedge fund strategies to volatility, market and credit risk is far from stable over time. What is moreimportant, the patterns of time varying risk exposure differ between the different strategies. At any point in time, while some strategies similarly reduce risk exposure, other strategies increase exposure to the same risk factor or leave it unchanged. It can also be seen that the level of risk exposure differs widely across strategies.

The FSR article's claim that hedge funds take positions in more and more illiquid securities is not substantiated by any data. The article merely states that "the liquidity of hedge fund investments may be decreasing, as recently hedge funds have reportedly been acquiring less liquid assets". While it is obviously difficult to obtain data on this topic, it is revealing for the article's methodology that a mere guess suffices to support the statement.

Most importantly, even if the claim of increasingly similar positions in illiquid securities corresponded to reality, this does not allow for the conclusion that adverse effects are likely to occur if investors start to redeem their shares in a massive way. In fact, hedge funds have a number of mechanisms that aim at matching funding liquidity and asset liquidity. In particular, lock-up periods – ranging from a month to more than a year – protect hedge funds from situations where they are obliged to sell assets due to decreasing funding liquidity. The FSR article itself asserts "a tendency […] to offer longer lock-up periods". Therefore, even if hedge funds are investing into more illiquid securities, sudden redemptions by investors may simply be impossible. In addition to lock-up periods, hedge funds typically require a notice period prior to redemption, further increasing the time to redemption for investors, and they charge redemption fees that give additional disincentives for sudden redemptions.
 

2. Hedge funds and systemic risk

The question of systemic risk of hedge funds is not new. Therefore, we propose a review of this topic, including positions taken by several regulatory authorities. It can be stated that the comments of most authorities – including prior research by the ECB – diverge clearly from the conclusions of the FSR article since they take a more nuanced point of view.

As explained in a recent study by the ECB (see ECB (2005)), hedge funds could affect financial stability through three channels: (i) "the failure of a large individual or a group of hedge funds could lead to far-reaching repercussions for exposed banks and financial markets"; (ii) "the serious mismanagement of exposures to hedge funds at an individual bank or banks might lead to a systemic crisis via contagion effects"; (iii) "instability could be initiated through the impact of hedge fund activities on financial markets".

Unfortunately, as stressed in Chan et al. (2005), "A definitive assessment of the systemic risks posed by hedge funds requires certain data that is currently unavailable, and is unlikely to become available in the near future, i.e., counterparty credit exposures, the net degree of leverage of hedge fund managers and investors, the gross amount of structured products involving hedge funds, etc. Therefore, we cannot determine the magnitude of current systemic risk exposures with any degree of accuracy".

Furthermore, as highlighted in a recent discussion paper by the FSA (see FSA (2005)), "the risk of an individual hedge fund posing a threat to the financial system on the scale of the LTCM episode, or even approaching it, has significantly diminished since 1998. This is primarily a consequence of enhanced risk management by hedge fund counterparties and the seeming absence of hedge funds with the level and nature of exposures taken on by LTCM". The same conclusion was drawn in a recent study by the ECB (see ECB (2005)).

Despite some evidence that hedge funds may engage in "crowded trades", the situation today is certainly better than before the LTCM crisis because: (i) banks use more sophisticated techniques to manage their exposures to hedge funds; (ii) as more players have entered the market, positions are probably much less concentrated in one or a few funds; and (iii) leverage levels taken on by funds are now lower. The Financial Economists' Roundtable (FER) concurs that "[…] systemic risk of a cascading nature that would jeopardize financial institutions is now small, but we recognize the inherent difficulty in drawing any firm conclusion in this regard".

It should be noted that no study has been able to demonstrate the implication of hedge funds in any systemic crisis, so far. As a matter of fact, the Financial Stability Forum (see Financial Stability Forum (2000)), in its report on highly leveraged institutions declined to conclude that hedge funds had compromised market integrity in the episodes it analyzed. In fact, often large international or domestic financial institutions and not hedge funds, turned out to have led or precipitated market crashes.

Secondly, it is worth noting that systemic risks are already indirectly controlled by regulators. We recall that hedge funds borrow money from regulated financial institutions, i.e., institutions that must monitor and control their counterparty risk. Had these financial institutions followed their internal risk control procedures properly, LTCM would not have been able to increase its leverage in such extreme proportions and the collapse would have been avoided, or in the worst-case scenario, its bankruptcy would have remained an idiosyncratic event.

In addition to an evaluation of potential systemic risks, there are undeniably some benefits from hedge fund activity. The ECB itself stresses in a recent study (see ECB (2005)) that "[…] hedge funds have a role as providers of diversification and liquidity, and they contribute to the integration and completeness of financial markets. […] As active market participants they often take contrarian positions, thus contributing to market liquidity, dampening market volatility and acting as a counterbalance to market herding. […] They thrive on perceivedinefficiencies by arbitraging away pricedifferences for the same risk across markets. In this way, hedge funds contribute to the price discovery process. It might also be argued that in this way, hedge funds have contributed to the further integration of financial markets".
 

Conclusion

Detailed discussion of the methodology and reasoning reveals that the FSR article's conclusion of a risk of "disorderly exits from crowded trades" is based on mere speculation. While the question of systemic risk is of importance, we do not dispose of enough data to reliably address this question at this stage (see Chan et al, 2005). For authorities in the financial markets, working towards obtaining such data would probably be worthwhile. In addition to evaluating systemic risks, the benefits offered by hedge funds should not be neglected when analysing the role they play in financial markets.
 

References

  • Chan, N., M. Getmansky, S.H. Haas, and A.W. Lo, 2005, "Systemic Risk and Hedge Funds", NBER Conference Paper, Risks of Financial Institutions.
  • EDHEC, 2005, "EDHEC European Alternative Diversification Practices Survey
  • European Central Bank, 2005, "Hedge Funds and their Implications for Financial Stability", Occasional Paper Series, No34, August 2005.
  • European Central Bank, 2006, Financial Stability Review, "Hedge Funds", Section 5.2., June 2006, pp. 133 – 142
  • Financial Services Authority, 2005, "Hedge Funds: A Discussion of Risk and Regulatory Engagement", Discussion Paper, No054, June 2005.
  • Financial Stability Forum, 2000, "Report of the Working Group on Highly Leveraged Institutions", April 2000.

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