Hedge fund contagion

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Hedge fund contagion

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Written by Robert Koller

Friday, 20 November 2009 18:28

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(Robert Koller, CAIA - www.HedgeFund-Lawyer.com)

The European Central Bank has just recently published under its working paper series a report on "Risk Spillover Among Hedge Funds - The Role of Redemptions and Fund Failures".

This working paper gives some interesting insight on the interconnectedness of hedge funds and how prone they are to be "infected" by "diseases" suffered by their peers in the same investment style and in other styles. It also takes a look on the benefits of diversification and identifies some of the metrics to be watched in order to predict hedge fund failure. The study by Benjamin Klaus and Bronka Rzepkowski has reviewed funds from the TASS database from January 1994 to May 2008. The paper measures the spill-over risk by the increase in the failure probability of hedge funds, which stems from redemptions or failures experienced by other hedge funds in previous months.

Contagion risks reviewed

The authors have investigated two risks which might increase the probability of hedge fund failure which could spill-over to their peers:

Redemptions by investors: Redemptions are considered to have negative effects on the remaining investors as fund managers are required to hold more cash, which reduces returns and which in turn will make the remaining investors also redeeming their participations in the relevant fund causing its failure. The authors call this effect "self-fulfilling run".
Failures of other funds: Prime brokers may take failures of other funds into account when assessing their risks. This could lead to a different, i.e. increased, perception of the risk by the prime broker(s) and lead them to tighten financial conditions, such as leverage or interest rates, to their hedge fund clients. These tightened conditions could propagate stress through to other funds. The paper cites Brunnermeier and Pedersen when speaking about a "margin spiral" and a "loss spiral". The former arises if higher margins/interest rates make the funding more difficult and as a consequence cause even higher margins/interest rates. The latter appears when losses on a fund's positions occur and force the fund to sell more of its assets which would cause a further decline in price. Both spirals seem to reinforce each other therefore having a worse effect than each taken for it alone.

Factors that influence fund failures

The authors have identified various factors that seem to have a statistical relevant influence on the failure of hedge funds. These criteria, some of them not very surprisingly and unfortunately not very elaborated, are: fund performance, capital withdrawals, assets under management, risk, redemption restrictions, age of the fund and investment style. Further they cite the case that investment companies may choose to close or liquidate a fund if it is not performing as well as comparable peers. The most significant indicators for hedge fund failure probability are investments in derivatives, redemptions in funds from the same style category and failures of other funds within the same investment styles.

But the article also includes unspecific factors which help to reduce the failure of hedge funds: size, capital flows, high watermark provisions and the notice period for redemptions. Further, but not as much as the preceding factors, the following are considered to help to avoid failure of funds (unfortunately again very unspecific): contemporaneous and past returns, payout and lock-up periods.

In light of these findings, it is suggested that hedge funds should disclose information to regulatory authorities on size, capital flows, restriction periods, incentive fees and on investments in derivatives. This could well be taken as a guidance for the drafting of the envisaged and highly controversial Alternative Investment Fund Managers Directive (AIFM, original text and new proposal) by the institutions of the European Union, since the AIFM is asking for far more disclosure and has a very different view on what is important. Interestingly, the working paper does not mention explicitly leverage (one of the main concerns of the AIFM) as a metric contributing to an increased failure probability.

Conclusions

Coming back to the originally reviewed reasons for spill-over, redemptions and failures of other funds, the paper finds that redemptions have a larger impact on fund failures' probability than the failure of other hedge funds. Further, it discovers that the contagion effect from both sources is much higher for funds in the same investment style than for funds using different strategies.

Hedge funds pursuing different strategies are only affected by investors' redemptions. An increase in redemptions reduces the failure probability of funds operating in the style category not affected by the redemptions, i.e. it is actually beneficial. A reason could be the re-allocation of investor funds from one hedge fund strategy to another one, unaffected by redemptions.

Finally, the article confirms what is almost natural; hedge funds that hold portfolios diversified in relation to the assets they hold or the geographical market they invest in, are less prone to failure than less diversified funds. Diversified funds also seem to be immune to an increase in the probility of failure by redemptions in other funds.