Post on 13-Jan-2017
The Role of Hedge Funds
in the Ongoing Financial Crisis
RESEARCH PAPER
MASTER PROJECT 2009
PROMOTED BY PROF. DR. CONSTANT BECKERS
Koen Van Overloop
Master of Financial Economics
Leuven School of Business & Economics
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KOE" VA" OVERLOOP
The Role of Hedge Funds
in the Ongoing Financial Crisis
ABSTRACT:
This paper analyzes the role of the hedge fund industry in the
current financial crisis. Empirical analysis of monthly hedge
fund index data indicates that the crisis has had a bigger impact
on hedge funds than vice versa. �o evidence is found that the
hedge fund industry bears more responsability for the global
financial turmoil than other private investors, institutional
investors or financial institutions. The data imply that hedge
funds even lowered their market exposure prior to the outbreak
of the subprime crisis, after severe losses in May 2006.
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Introduction
This paper uses monthly index data to analyze hedge fund performance during the 2007-09
financial crisis. The goal is to find out whether hedge funds are responsible for causing some
of the dramatic events of the financial turmoil or have simply been victims of the global
financial meltdown. The first chapter deals with everything there is to know about hedge
funds: characteristics, strategies and impact on the financial markets. The second chapter
presents the data and overall performance of the hedge fund industry between 1994 and 2008.
The final chapter deals with the role of the hedge fund industry in the ongoing financial crisis.
1. Hedge Fund Basics
Hedge funds pool large amounts of capital and use complex investment strategies to invest the
acquired capital. Hedge fund managers enjoy a great deal of freedom: they can take long
and/or short positions, use derivatives and leverage. Hedge funds attempt to find trades that
are almost arbitrage opportunities, so they basically try to earn low-risk profits by taking
advantage of price discrepancies (pricing mistakes) in the markets between securities. Once
mispriced assets are identified, they construct hedges for the positions taken. The result is that
the hedge fund benefits from the mispricing correction whilst being affected by little else.
1.1 Hedge Funds vs. Long-only Funds
Hedge funds essentially have the same economic function as mutual funds, they can privately
issue securities and their investors have to meet requirements set out by the financial
regulator. Hedge funds exist because mutual funds can not work with complex investment
strategies due to strict regulation. The extensive diversification restrictions and disclosure
requirements constrain their ability to exploit perceived opportunities and hedge positions
using derivatives and short-selling. Hedge funds cunningly avoid strict regulation by
operating from tax-havens, limiting the number of potential investors and giving up the right
to make public offerings. In return, hedge funds can take very large positions in the financial
markets with a limited amount of money because they can simultaneously take cash, long and
short positions, as opposed to traditional long-only funds that can only have cash and long
positions. Hedge funds are also allowed to make use of derivatives and leverage for the
purpose of taking both long and short positions in the market. Hedge funds may agree
contractually to disclose some types of information and to provide audited financial
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statements, if they decide that it helps them to recruite investors, but they are not required to
do so.
While mutual funds determine their relative return objectives by using benchmarks, hedge
funds set absolute return targets that are often independent of market conditions (Stulz, 2007).
Hedge fund investors can only withdraw their capital on a monthly or quarterly basis (the
latter are most common), which allows hedge funds to invest in less liquid assets and
securities. The management compensation structures differ as well: mutual funds usually
charge a management fee of a few percent of the managed capital, hedge funds on the other
hand usually charge a fixed fee of ±2% of the managed capital plus a variable fee of ±20% of
any earnings over and above the return target (Strömqvist, 2009).
1.2 Hedge Fund Strategies
Hedge Fund Research Inc. classifies hedge funds into 4 major categories: Equity Hedge,
Event-Driven, Macro and Relative Value (HFR, 2009). Equity Hedge strategies take both
long and short positions in equity and equity derivative securities. Decision are made using
both fundamental and quantitative techniques and strategies can be very diversified or very
focussed on specific sectors. The Equity Hedge category includes strategies like Equity
Market Neutral, Fundamental Value and Short Bias. The second hedge fund category, Event
Driven, consists of funds that take positions in companies that are involved in corporate
transactions like mergers, restructurings, tender offers, shareholder buybacks or companies
that are in financial distress. Event Driven funds are mainly exposed to the credit and equity
markets. The Event Driven category includes strategies like Distressed/Restructuring, Credit
Arbitrage and Merger Arbitrage.
The third category, Macro, consists of funds that make investment decisions by observing
economic variables and by trying to predict the impact of movements in these variables on
equity, currency and commodities. There are some similarities to other categories: like the
first category (Equity Hedge), Macro strategies can use equity securities. They also
sometimes use techniques similar to the ones the Relative Value category (the 4th major
category) employs. Macro strategies distinguish themselves from these categories through
their focus on the underlying economic variables rather than simple pricing discrepancies
between securities.
Relative Value, the last category, mainly consists of fixed income strategies that exploit
pricing and valuation discrepancies in the complex relationship between multiple securities.
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These strategies are often quantitatively driven as they measure the relationship between
instruments in order to identify positions where the spread creates an attractive opportunity.
The hedge fund industry has grown exponentially over the last decade. In 1996,
approximately 2000 hedge funds managed about $135bn, two years ago over 10 000 hedge
funds together managed more than $2,000bn. Hedge funds did not only increase in average
size but the range of strategies adopted also evolved. Figure 1 shows how the industry’s
Assets-Under-Management (net market value in dollars) are distributed over the various
hedge fund strategies. Ten years ago, one third of all hedge funds were global macro funds.
Nowadays global macro funds account for only a small share of the industry, as the most
common strategies are equity-based arbitrage strategies, attempting to track down market
mispricing.
Figure 1: Distribution of total industry-managed capital over strategies (1994-2008)
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1994 1996 1998 2000 2002 2004 2006 2008
Short Bias
ConvArbitrage
Man Futures
Multi-Strategy
Eq Mkt Neutr
Emerging Mkts
Fix Inc Arbitr
Event Driven
L/S Equity
Global Macro
Source: Credit Suisse / Tremont historical hedge fund sector weights.
1.3 Impact on Financial Markets
Hedge Fund Research estimated that global hedge fund capital in september 2008 was $1.72
trillion. Hedge funds are very active and agressive traders that operate with large sums of
money, which is exactly why the hedge fund industry, and sometimes even an individual
fund, can have a significant impact on financial markets, despite the fact that it is a lot smaller
than the mutual fund industry. Hedge funds have two functions in financial markets:
arbitrager and liquidity provider. Both functions have potential positive and negative effects.
As arbitragers, hedge funds look for mispricings, which they exploit when they occur, hereby
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improving pricing and market efficiency. Unlike most other players, hedge funds are very
active and constantly buying and selling, which helps to provide increased liquidity and
efficient pricing in the markets. The flexibility of hedge funds can also create problems, as
high degrees of leverage entail serious risks: high leveraged funds are more likely to fail if
wrong investments are made. High leverage also increases the risks for the counterparties of
the hedge fund, in that case failure of the fund can have contagion effects that spread fast in
the financial system. The risks linked to high leverage are not the only factor that hedge funds
have to deal with: their extensive use of derivatives is also potentially dangereous. Derivatives
allow hedge funds to take large and risky positions in the market with only a small amount of
capital, this way managers can obtain additional leverage.
1.4 Accusations of Market Manipulation by Hedge Funds
Over the past 20 years, hedge funds were often accused of market manipulation: critics said
that high-leveraged hedge funds used speculative attacks to manipulate asset prices and
financial bubbles. Large scale speculative attacks inject a great deal of uncertainty in the
financial system and often generate herd behaviour. The use of derivatives and high leverage
in the hedge industry makes it possible even for single hedge funds to adopt immense
positions on the market for only a small capital contribution. Few outsiders know exactly how
much capital hedge funds hold, what strategies they use and how much leverage is used. This
veil of secrecy under which the hedge fund industry has operated does not facilitate
investigations about its role in any financial crisis (Trejos, 2008). Four important financial
crises of the last 20 years will be briefly discussed, with a focus on hedge fund involvement.
(a) European Currency Crisis in 1992
The currency crisis in 1992 is a perfect example of how the behavior of an individual hedge
fund can have a profound influence on prices. Quantum Fund, a global macro fund lead by
George Soros, speculated against several fixed European exchange rates in the early 1990s.
Soros was convinced that the exchange rates did not correspond with the macroeconomic
conditions in those particular countries. When Quantum Fund sold large volumes of currency
in 1992, Sweden and the UK were forced to abandon the fixed exchange rates and the value
of these currencies declined rapidly. Quantum Fund was able to make billions and Soros’
speculative attacks came under heavy criticism. Soros responded that the valuation of the
currencies was obviously incorrect and an adjustment of the currency prices was bound to
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occur sooner or later. While it is true that the speculative attacks of Quantum Fund had a
significant impact on currency prices, this alone can hardly be labeled ‘manipulation’ as the
bubble was obviously the result of an erroneous monetary policy and a price adjustment was
needed to bring the currency prices closer to their fundamental values.
If global macro funds artificially created the bubble for their own gain, then strong positions
taken right before the bubble bursted should pay off in the form of very high fund returns.
Yet, this strong increase is only noticeable in returns of Quantum Fund and not in the global
macro index. The global macro index increased with less than 5% during the entire currency
crisis and the subsequent months (the 2nd half of 1992). It is therefore reasoneable to assume
that the average global macro hedge fund did not abnormally benefit from the 1992 currency
crisis (Strömqvist, 2009).
(b) Asian Crisis in 1997
Several South-East Asian countries had large deficits on their current accounts in the mid
1990s. Combined with their fixed exchange rates against the US dollar this caused a financial
bubble to develop. The bubble exploded after Thailand devaluated its currency in the summer
of 1997, quickly followed by Malaysia and South-Korea, with dramatic price effects on the
financial markets.
Figure 2: Cumulative returns, Asian crisis (index May 1997 = 100)
20
40
60
80
100
120
140
160
Jul 1997 Jan 1998 Jul 1998 Jan 1999
Hedge Fund index Emerging Markets index Global Macro index
Source: Hedge Fund Research Inc.
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Hedge fund performance in this period is shown in Figure 2 and presents a positive and
stabile growth in returns, although performance was not very good compared to the previous
years. Emerging Market hedge funds performed very bad: cumulative returns had dropped
with 40% between May 1997 and September 1998. The bursting of the financial bubble
caused major asset price adjustments and some market participants accused hedge funds of
collectively speculating against the Asian economies. These allegations were even
investigated in 1998 by the IMF (Strömqvist, 2009). However, Eichengreen et al (1998) did
not found evidence of a collective attempt by hedge funds to undermine the Asian economies
through herd behavior, speculative attacks or positive feedback trading. Fung & Hsieh (2000)
used regression analysis to test for negative correlation between Asian currency innovations
and hedge fund returns, however the results did not indicate any involvement of hedge funds
in collective speculative attacks on Asian markets. Lindgren (1999) concluded that hedge
funds did not play a prominent role in the Asia crisis; the financial bubble bursted as
international investors panicked and quickly extracted all their capital out of South-East Asia.
(c) Long-Term Capital Management (1998)
Long-Term Capital Management was a well-known arbitrage hedge fund that exploited
mispricings, mainly in bond markets, but almost went bankrupt in August 1998. At that time,
the fund had an extremely high degree of leverage of 25 times the value of the equity. LTCM
got in trouble when market conditions changed radically after the Russian financial collapse.
In the end, the Federal Reserve was forced to intervene in order to ensure financial stability by
bailing out LTCM. The collapse of LTCM showed the potential systemic risk posed by the
hedge fund industry. Bankrupt hedge funds with a high degree of leverage can drag down
other funds and market counterparts in their fall, for example when large open positions have
to be liquidated at fire sale prices. This could seriously damage the counterparty and also
affect the value of similar assets in the markets. These direct losses are catastrophical if they
cause more defaults or threaten systemically important institutions. Other market participants,
besides creditors and counterparties of the defaulting firm, can be affected indirectly through
adjustments of asset prices, liquidity strains and changes in market uncertainty (Bernanke,
2006).
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(d) Dot-com Bubble (2000-01)
An IT-related speculative bubble had been developing on the Western stock markets since
1995 as the new Internet-related sector experienced explosive growth and increasing
popularity. The prices of dot-com shares kept rising throughout 1999 and reached extremely
high levels in March 2000. The market trend then suddenly reversed as investors realized that
the market values of shares were disconnected from the fundamental values and prices started
to decrease rapidly.
Figure 3: Cumulative returns, Dotcom crisis (index Jan 1999 = 100)
70
80
90
100
110
120
130
140
150
160
Jan 1999 Jul 1999 Jan 2000 Jul 2000 Jan 2001 Jul 2001
Hedge Funds MSCI World Russell 3000 Global Macro
Sources: Hedge Fund Research Inc. & Thomson Datastream
Figure 3 shows something interesting: the hedge fund index grows at a similar rate as equity
indices before the bubble bursted. By March 2000, investors started dumping assets in the
markets which caused prices of IT-related shares to fall heavily causing crashes on Western
stock markets. In comparison, the hedge fund index only lost a few procent in that month and
quickly recovered to show positive growth. This strange relationship between the indices
seems to indicate that hedge funds took significant long positions during the bubble but left
the stock markets before the turning point in March 2000. Brunnermeier & Nagel (2004)
found evidence supporting the hypothesis that hedge funds held long positions in IT-stocks
but reduced their holdings before the crash.
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This shows that hedge funds did not observe these events from the sideline but were actively
involved in these events, but it is very hard to find out whether they manipulated the financial
bubble and markets to make profits. There is some evidence for rejecting the hypothesis of a
collective speculative attack on IT-related shares. The fact that hedge funds increased their
holdings in IT-shares during the bubble shows that they did not consider themselves
influential enough to cause the market to crash. This is important: if hedge funds had not sold
their entire IT-holdings when the bubble bursted, they would not gain from going short and
thus push prices down because they still had long positions. So a collective speculative attack
by the hedge fund industry on IT-shares can be ruled out. It is impossible to say something
about the involvement of specific individual hedge funds (Brunermeier & Nagel, 2004).
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2. Hedge Fund Performance Since 1994
2.1 Data
The data used are monthly rate of returns of global, regional and sectoral hedge fund indices,
provided by Hedge Fund Research Inc, a research firm on alternative investments. Data
before 1994 were excluded and the database does not include data prior to that year. The
unreliability of data before 1994 is extensively discussed by Fung & Hsieh (2000), Liang
(2000) and Li & Kazemi (2007).
Hedge fund data is generally of poor quality as it suffers from various biases of which
survivorship bias is the most prominent. Survivorship bias is often defined as the difference in
fund returns between the surviving funds and the dissolved funds (Ackermann et al, 1999) or
the difference between the returns of the surviving funds and all funds (Liang, 2000).
Backfilling bias is caused by the backfilling of historical returns when new funds are added to
the database (Eling, 2008). For example single strategy hedge fund returns, especially prior to
1994, are upwardly biased between 50 and 300 basis points per year according to various
academic papers on the subject (Ineichen & Silberstein, 2008).
The HFR dataset provides information about hedge funds both living and dead. It is known to
have a lower attrition rate compared to other frequently used databases such as TASS (see
Liang (2000)), which suggests that fewer dissolved funds are concluded compared to other
databases. Using the HFR database limits the problems caused by survivorship bias. HFR
tries to mitigate the problem of spurious inferences caused by survivorship-related issues a la
Brown et al. (1992), (1999) by including data on both living as well as dead hedge funds.
2.2 Overall Performance between 1994 and 2008
Hedge funds on average have performed well over the last 15 years compared to mutual funds
or to the whole stock market (Strömqvist, 2009). Table 1 presents the descriptive statistics of
the hedge fund indices: the first panel for all hedge fund strategy indices, the second panel for
the funds of funds index and the last panel for 5 passive benchmark indices. The MSCI World
Index contains a number of 'world' stocks from all developed markets (as defined by MSCI)
and serves as the worldwide equity market proxy. The index is a common benchmark for
global stock funds and securities from 23 countries are included. The MSCI World ex US
Index excludes the United States and MSCI Europe contains only European stocks). All
MSCI indices used here are for the period 1994-2008 and were calculated in US dollar. The
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J.P. Morgan Global Government Bond Index contains bonds issued worldwide by national
governments and this paper uses this index as a proxy for a global risk-free rate of return. The
remaining two benchmarks are two American indices (NYSE Composite Index and S&P500
Composite Index) and are both considered important worldwide.
Table 1: Descriptive Statistics for Monthly Returns Strategies & Benchmarks (1994-2008)
Mean Return
(%)
St. Dev (%)
Skew-ness
Excess Kurtosis
Jarque-Bera prob.
Mean Excess Return
Sharpe Ratio
Mean Diff.
Return
Mkt. Share3
All Hedge Funds 1 0.78 2.13 -0.70 2.71 0.00 0.67 0.31 0.57 67 %
Distressed 0.73 1.81 -1.82 6.71 0.00 0.62 0.34 0.54 6.1 %
Emerging Mkts 0.68 4.00 -2.07 12.83 0.00 0.57 0.14 0.39 12 %
Eq Long/Short 0.89 2.72 -0.21 2.37 0.00 0.77 0.28 0.65 8.7 %
Eq Mkt. Neutral 0.55 0.94 -0.21 1.50 0.00 0.44 0.47 0.40 2.1 %
Event Driven 0.84 2.02 -1.40 4.58 0.00 0.72 0.36 0.63 6.3 %
Fix Inc Arbitr. 0.46 1.93 -5.10 36.77 0.00 0.35 0.18 0.26 4.3 %
Global Macro 0.79 1.99 0.09 1.01 0.02 0.68 0.34 0.59 3.6 %
Multi-Strategy 0.47 1.26 -3.26 17.63 0.00 0.36 0.29 0.31 7.0 %
All Fund of Funds 2 0.47 1.83 -0.69 3.57 0.00 0.36 0.20 0.28 33 %
Benchmark Indices
MSCI World 0.32 4.54 -0.87 4.41 0.00 0.21 0.05 0.00
MSCI World ex US 0.23 4.69 -0.70 2.65 0.00 0.12 0.03 -0.10
MSCI Eur 0.42 4.94 -0.74 2.50 0.00 0.30 0.06 0.08
JPM Glob Gov Bonds 0.11 2.03 0.27 -0.24 0.27 0.00 0 -0.09
NYSE Comp. 0.50 4.61 -1.17 5.95 0.00 0.39 0.08 0.18
S&P 500 Comp. 0.47 4.81 -0.89 4.59 0.00 0.36 0.07 0.14
Sources: Barclayhedge.com, Hedge Fund Research Inc. and Thomson Datastream. 1 Fund weighted composite
index that includes 2000 constituent funds, excl. funds of funds). 2 Fund of funds composite index that includes 800
constituent funds, excl. hedge funds). 3Market share = % of total industry-managed assets (hedge funds + funds of
funds, in $) managed by funds of that strategy (in Q2 2008). Retrieved on March 11, 2009 from
http://www.barclayhedge.com/research/indices/ghs/ mum/hf_ Money_Under_ Management.html.
Columns 2 to 5 of Table 1 show the first four moments of the return distribution: the mean,
standard deviation, skewness and excess kurtosis (kurtosis minus 3). Column 6 shows the
Jarque-Bera probability that the returns are normally distributed. Column 7 shows the mean
excess return (the average difference between the return and the risk-free rate of return) that
was used to calculate the Sharpe ratio’s in Column 8. The Sharpe ratio (or reward-to-
variability ratio) is a measure of excess return, or risk premium, per additional unit of risk.
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Sharpe’s (1966) original index is defined as follows:
where is the asset return, is the risk free rate of return. The Sharpe ratios in column 8
were calculated using the mean monthly return of fund or benchmark index as return R, the
mean monthly return on the JPM Global Government Bond Index as a proxy for the risk-free
rate of return and the standard deviation of the monthly index/fund returns . Column 9 of
Table 1 presents the mean differential return, the excess return over a benchmark portfolio
with the same risk, defined as:
.
The MSCI World Index was used as world equity market proxy. The mean differntial return is
an alternative for the Sharpe ratio, and in most cases will not generate qualitatively different
results as the Sharpe ratio, but the oucome can slightly differ when you make rankings of
funds or strategies. The global fund weighted index for the hedge industry generated a mean
monthly return of 0.78%, which is about 9.36% annually (assuming that investors can only
reinvest profits or withdraw capital on an anual basis), while Funds of Funds generated a
mean monthly return of 0.47% (5.64% annually).
The best performing strategies were Equity Long/Short (0.89% monthly, 10.68% annually),
Event Driven (0.84% monthly, 10.08% annually) and Global Macro (0.79% monthly, 9.48%
annually). The least best performing hedge fund strategies are Fixed Income Arbitrage (0.46%
monthly, 5.52% annually) and Multi-Strategy (0.47% monthly, 5.64% annually). The
strategies from the Equity Hedge category, Equity Long/Short and Equity Market Neutral,
performed well relative to the equity benchmarks (MSCI World and S&P 500). The Fixed
Income Convertible Arbitrage strategy was one of the least best performing hedge fund
strategies, but the strategy still performed very well relative to the fixed income benchmark,
the JPMorgan Global Government Bonds Index (0.11% monthly, 1.32% annually).
It is clear that hedge funds on average generate higher returns than the market benchmarks,
but its also important to see how volatile these returns are compared to the benchmarks. The
global fund weighted index has a standard deviation little over 2%, which is about the same as
the standard deviation of the bond market benchmark and half of the equity market
benchmark standard deviations. So hedge funds on average do not only generate higher
returns, but these returns are also significantly less volatile than the market returns. The
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performance measurement results provide significant evidence of superior hedge fund
performance over longer periods of time: both hedge funds and funds of funds generate
relatively high returns with low volatility when compared to the benchmarks.
Skewness, a measure of the asymmetry of the returns’ probability distribution, is negative for
all hedge fund strategies, except for Global Macro strategies (skewness close to zero). Fixed
Income Convertible Arbitrage strategies show very negative skewness. Kurtosis is a measure
of the peakedness of the returns’ probability distribution: a high kurtosis distribution has a
sharper peak and long fat tails, while a low kurtosis distribution has a more rounded peak and
short thin tails. The normal distribution has a kurtosis of 3, so it is more interesting to observe
the excess kurtosis (kurtosis minus 3). The bond market benchmark is slightly platykurtotic,
meaning that it has a slightly negative excess kurtosis. All other benchmarks and hedge fund
strategies are leptokurtotic, meaning that they have a positive excess kurtosis. The Equity
Market Neutral and Global Macro strategies are slightly leptokurtotic while most strategies
have very leptokurtotic. Emerging Markets, Fixed Income Convertible Arbitrage and Multi-
Strategy have very high excess kurtosis, ranging from 17.63 to 36.77. It was already obvious
that the returns of most hedge funds and funds of funds are not normally distributed. This is
confirmed by the Jarque-Bera normality test results: the probabilities that returns are normally
distributed are equal to or close to zero for all benchmarks and strategies, except for the bond
market benchmark (p-value = 0.27). The Sharpe ratio, which takes investment risk into
account, shows that all hedge fund strategies offer a good tradeoff between return and risk,
relative to the benchmarks. The hedge fund strategies with the best Sharpe ratios are Equity
Market Neutral (0.47), Event Driven (0.36), Distressed (0.34) and Global Macro (0.34). The
lowest Sharpe ratio is obtained by Emerging Markets (0.14) and Fixed Income (0.18). Most
hedge fund strategies provide a very high Sharpe ratio compared to the benchmark indices.
Table 2 presents the correlations of hedge fund strategies and the market benchmark indices.
Hedge funds in general show strong positive correlation with equity market indices: between
0.4 and 0.5, and weak negative correlation with the bond market benchmark (-0.09). The
strategies with very strong equity market correlations (> 0.5) are Distressed, Event Driven,
Equity Market Long/Short, Fixed Income and Multi-Strategy. Equity Market Neutral and
Global Macro strategies show the weakest equity market correlations: 0.25 and 0.26. So these
two strategies managed to be partially equity market independent, but did not succeed to be
100% market neutral.
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Table 2: Correlations Strategies & Benchmarks (1994-2008)
MSCI WORLD
MSCI EX US
MSCI EUR
JPM GGB
NYSE
S&P
500
DISTRESSED 0.56 0.55 0.56 -0.05 0.57 0.53
EMERGING MKTS 0.45 0.45 0.44 -0.05 0.42 0.40
EQ LONG/SHORT 0.51 0.49 0.49 0.00 0.47 0.49
EQ MKT NEUTR 0.25 0.23 0.24 -0.01 0.29 0.26
EVENT DRIVEN 0.58 0.54 0.55 0.00 0.58 0.56
FIX INC. ARBIT 0.51 0.48 0.49 0.03 0.55 0.50
GLOBAL MACRO 0.26 0.27 0.31 0.10 0.23 0.22
MULTI-STRAT. 0.56 0.55 0.56 -0.02 0.56 0.52
ALL HEDGE FUNDS 0.46 0.47 0.45 -0.09 0.45 0.42
FUNDS OF FUNDS 0.52 0.52 0.52 -0.04 0.48 0.47
Sources: Hedge Fund Research Inc. and Thomson Datastream
Table 3 shows the correlations of hedge fund strategies and market indices for the years in the
sample period when the general market climate was bullish (1994-1999, 2002-2006), Table 4
on the next page for the years in the sample period when the market climate was bearish
(2000-02, 2007-09). When comparing both tables, the first remarkable observation is the fact
that the correlations of hedge fund strategies with global equity markets are generally a lot
stronger during bearish periods than during bullish periods! Even the correlation of Equity
Market Neutral with equity markets increases from 0.22 to 0.27, although this is a moderate
increase compared to most other strategies.
Table 3: Correlations in Bull Markets (1994-99, 2002-06)
MSCI WORLD
MSCI EX US
MSCI EUR
JPM GGB
NYSE COMP.
S&P 500 COMP.
DISTRESSED 0.46 0.42 0.44 0.00 0.51 0.46
EMERGING MKTS 0.37 0.35 0.32 -0.08 0.38 0.35
EQ LONG/SHORT 0.45 0.38 0.38 0.03 0.45 0.47
EQ MKT NEUTR 0.22 0.19 0.24 0.07 0.24 0.23
EVENT DRIVEN 0.51 0.43 0.43 0.04 0.54 0.53
FIX INC. ARBIT 0.42 0.36 0.38 0.12 0.46 0.44
GLOBAL MACRO 0.34 0.33 0.37 0.11 0.33 0.31
MULTI-STRAT. 0.48 0.47 0.49 -0.03 0.47 0.43
ALL HEDGE FUNDS 0.40 0.38 0.37 -0.09 0.44 0.39
FUNDS OF FUNDS 0.44 0.40 0.41 -0.01 0.44 0.42
Sources: Hedge Fund Research Inc. and Thomson Datastream
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Table 4: Correlations in Bear Markets (2000-02, 2007-09)
MSCI WORLD
MSCI EX US
MSCI EUR
JPM GGB
NYSE COMP.
S&P 500
DISTRESSED 0.63 0.67 0.66 -0.16 0.55 0.58
EMERGING MKTS 0.59 0.65 0.67 0.00 0.49 0.48
EQ LONG/SHORT 0.53 0.59 0.59 -0.08 0.45 0.44
EQ MKT NEUTR 0.27 0.26 0.22 -0.15 0.25 0.34
EVENT DRIVEN 0.63 0.66 0.67 -0.09 0.56 0.58
FIX INC. ARBIT 0.61 0.62 0.61 -0.05 0.57 0.64
GLOBAL MACRO 0.03 0.08 0.11 0.05 -0.02 -0.03
MULTI-STRAT. 0.61 0.62 0.63 -0.05 0.56 0.62
ALL HEDGE FUNDS 0.49 0.54 0.51 -0.12 0.40 0.41
FUNDS OF FUNDS 0.58 0.65 0.65 -0.11 0.49 0.50
Sources: Hedge Fund Research Inc. and Thomson Datastream
Global Macro is the only hedge fund strategy that manages to offer its investors an actual
equity market ‘hedge’, as in offering them limited potential losses and at the same time
unlimited potential profits. During bullish periods, Global Macro funds show moderate
positive correlation with global equity markets (between 0.3 and 0.4) and weak positive
correlation with global bond markets (0.1). In contrast: during bearish periods the strategy
manages to become almost global equity market neutral: this correlation (MSCI World) drops
from 0.34 to 0.03. The correlation with the MSCI World ex US Index also goes down
drastically from 0.33 to 0.08, which is a smaller decrease than the decrease of correlation,
with MSCI World, but still a large decrease. Global Macro even shows slightly negative
correlation with U.S. equity markets during bearish periods: the correlation decreases from
0.31 to a staggering -0.03!
2.3 Market Adjusted Model
First, a market adjusted model is estimated, the regression specification is as following:
To estimate the market adjusted model, the excess returns (over the risk free return) of the
hedge fund strategy indices are regressed on the excess returns of a world equity market
benchmark index: the MSCI World Index. The above model was also estimated with
additional benchmarks for bonds (JPMorgan GGB index) and commodities (Goldman Sachs
Commodity Index indices) but these coefficients were nowhere near significant.
16
The CAPM model predicts that all α’s will be equal to 0. According to the CAPM only the β’s
should matter, as they measure the sensitivity of the sector returns relative to the global stock
market returns. Estimation results are presented in Table 5: the estimated alpha’s can be found
in column 2, the beta’s and Adjusted R² can be found in columns 3 and 4.
Table 5: Market Adjusted Model (1994-2008)
α
β1
Adj. R²
DISTRESSED 0.55 ** 0.36 ** 0.40
EMERGING MARKETS 0.47 0.51 ** 0.30
EQUITY LONG/SHORT 0.69 ** 0.42 ** 0.37
EQUITY MKT NEUTRAL 0.40 ** 0.21 ** 0.20
EVENT-DRIVEN 0.64 ** 0.38 0.43
FIXED INC ARBITRAGE 0.28 0.34 ** 0.37
GLOBAL MACRO 0.63 ** 0.24 ** 0.19
MULTI 0.30 * 0.30 ** 0.36
FUND WEIGHTED COMP 0.59 ** 0.36 ** 0.36
FUND OF FUNDS 0.29 0.34 ** 0.37
Sources: Hedge Fund Research Inc. and Thomson Datastream.
*(* *) indicates significance at the 5 % (1%) level
Strong evidence of superior hedge fund performance is found using the market adjusted
model: all estimated alpha’s are positive. The alpha of the fund weighted composite index
(which represents the entire hedge fund industry) is positive and statistically significant at the
1% confidence level. Five strategies (Distressed, Equity L/S, Equity Market Neutral, Event
Driven, Global Macro) are statistically significant at the 1% confidence level and one strategy
at the 5% confidence level (Multi-Strategy). The Fund of Funds index generates a positive
alpha but it is not statistically significant. The third column of Table 5 presents the beta
estimations, which were all statistically significant at the 1% confidence level with the
exception of the Event-Driven beta. Equity Market Neutral (0.21) and Global Macro (0.24)
have the lowest beta, Emerging Markets (0.51) and Equity Long/Short (0.42) have the highest
beta. It is quite obvious that none of the strategies comes anywhere near total market
neutrality.
The Adjusted R² indicates the fraction of variance in the returns that can be explained by
innovations in the model factors, so basically it tells us to what extent systematic risk explains
the hedge fund strategy returns. The Adjusted R² varies between 0.19 (Global Macro) and
17
0.49 (Distressed). The Fund Weighted Composite index has an Adjusted R² of 0.36, so 36%
of the variance of its returns can be explained by innovations in the MSCI World index, the
global equity market benchmark. The R² of the Fund of Funds index is about the same. So we
can say that a significant part of hedge fund returns depends on the global equity market
returns but the industry also generates a signifcant positive return that can not be explained by
the returns of global equity markets. For the strategies, the model is quite powerful for
Distressed, Equity Long/Short, Event Driven, Fixed Income Arbitrage and Multi. These
results are as expected, as it was already shown in the previous section that Global Macro
Hedge Funds & Equity Market Neutral Funds had weak correlation with global equity
markets, which implies low systematic (or market) risk and thus a low R². (1-R²) can be
interpreted as the idiosyncratic risk with respect to a particular hedge fund strategy. The low
value of R² does not necessarily mean that the CAPM predictions are not valid, it simply
suggests that the strategy returns are characterized by a large idiosyncratic risk component.
2.4 Measurement of Performance Persistence
The estimated market adjusted model in the previous section provided a positive and
significant α for 5 of the 8 hedge fund strategies. Does this automatically imply that hedge
fund returns are characterized by performance persistence? A way to find out whether there is
performance persistence is to test if past performance is a good predictor for performance in
the next period (see e.g. Grinblatt & Titman 1993, Kahn & Rudd 1995 and Brown et al.
1999). The statistical significance of the relationship between performance in a certain period
and performance in the previous period can be established on the basis of ex post values,
using the following regression:
with and respectively representing the returns in the periods t and t-1. Returns during
the current period are regressed on the returns of the previous period, a positive significant
slope coefficient indicates performance persistence. The statistical significance of the β’s can
be tested using the T-statistic: a T-value greater than 1.96 (2.57) indicates significant
persistence at the 5% (1%) confidence level. α is the part of the return that can not be
explained by the return of the previous period. Hedge fund strategies that are faily illiquid by
nature (e.g. fixed income-convertible arbitrage) are expected to show higher persistence than
more liquid fund. Short-term persistence is reported by nearly all studies but evidence for
18
long-term persistency is mixed. For each fund strategy, estimations were done using monthly
returns (raw, excess over market and over riskfree-rate) for horizons of 1, 3, 6 and 12 months,
can be found in the tables in the appendix. Performance persistence has been very high over
the last 2 years (2006-08) with a significant β (1% level) of 0.48, also the Adjusted R² was
relatively high compared to other subperiods. Monthly and semi-annual Equity Hedge returns
are persistent over the whole sample period, as shown by the positive and significant β’s (at
the 1% confidence level). The Global Macro category generates large and highly significant
α’s (1% level) for the whole sample period, for all subperiods and over all horizons. During
the total sample period, Global Macro funds generate returns that are persistent, both in the
short and the long run, but that can not be predicted just by looking at their past performance.
Clearly there must be other variables that can help to explain these high returns.
The relatively low R² in the estimation results of the market adjusted model (see previous
section) and the relatively weak correlation with the market benchmarks in Table 2 indicate
that the benchmark indices do not help to predict changes in Macro Hedge returns in the
following period. Macro-economic variables like interest rates, production, inflation and oil
prices are possibilities. Finally, Fixed-Income Arbitrage returns are not as high as the average
returns over all fund styles, but they are highly persistent for horizons of 1 month (β = 0.59), 3
months (β = 0.70) and 6 months (β = 0.96). The high values for the Adjusted R² indicate that
for any given period, the return can partially be predicted by using the return of the previous
period. Overall, the Adjusted R² are fairly low for all hedge fund styles, periods and horizons.
This could be explained by the fact that changes in hedge fund returns are caused by
combinations of multiple variables. Alternatively, the Adjusted R² are low because the OLS
estimation method relies on the normality assumption. It is generally known that hedge fund
returns are not normally distributed, but are negatively skewed.
Table 6 provides a complete overview of performance persistence for (excess) returns of all
fund strategies for horizons of 1, 3 and 6 months. The extensive results can be found in Table
7 and 8 in the Appendix. The table allows us to compare persistence of total monthly returns,
excess returns over the risk free rate and excess returns over the market rate (MSCI World
Index). Looking at monthly excess returns over the risk free rate (column 6 of Table 6), the
hedge fund industry shows persistent performance over the total sample period and mainly in
bullish markets; the same is found for Funds of Funds. Distressed, Equity Long/Short and
Event-Driven strategies also show performance persistence for the total sample period and in
19
bullish markets. Fixed Income Arbitrage shows persistent performance for the total sample
period between 1994 and 2008. No evidence whatsoever is found for performance persistence
regarding the monthly excess returns over the market rate (MSCI World index) in column 7 of
Table 6, which can be thought of as alpha. The results discussed above point to the existence
of short-term persistence in total monthly returns, but little evidence is found for the existence
of long-term persistence in total monthly returns or persistence in monthly excess returns over
the risk free rate or the market rate.
Table 6: Performance Persistence Overview
MONTHLY RETURNS MONTHLY
EXCESS RETURN
1M 3M 6M RF RMSCI
Distressed 1994-2008 � � � � �
Bullish ↗ � � � � �
Bearish ↘ � � � � �
Emerg Mkts 1994-2008 � � � � �
Bullish ↗ � � � � �
Bearish ↘ � � � � �
Equity L/S 1994-2008 � � � � �
Bullish ↗ � � � � �
Bearish ↘ � � � � �
Eq. Mkt Neut. 1994-2008 � � � � �
Bullish ↗ � � � � �
Bearish ↘ � � � � �
Event-Driven 1994-2008 � � � � �
Bullish ↗ � � � � �
Bearish ↘ � � � � �
Fix Inc Arbitr 1994-2008 � � � � �
Bullish ↗ � � � � �
Bearish ↘ � � � � �
Global Macro 1994-2008 � � � � �
Bullish ↗ � � � � �
Bearish ↘ � � � � �
Multi-Strat 1994-2008 � � � � �
Bullish ↗ � � � � �
Bearish ↘ � � � � �
All Hedge Funds
1994-2008 � � � � �
Bullish ↗ � � � � �
Bearish ↘ � � � � �
Funds of Funds 1994-2008 � � � � �
Bullish ↗ � � � � �
Bearish ↘ � � � � �
The � symbol indicates performance persistence of the monthly (excess)
returns that is statistically significant at the ≤ 5% confidence level.
20
3. The Global Financial Crisis of 2007-2009
3.1 Subprime Mortgage Crisis
During the 1990ies, Western economies accomplished strong economic growth, booming
financial markets (for example the dot-com hype) and low interest rates. After the dot-com
bubble bursted in 2001, Americans considered real estate to be a good and safe investment.
The subsequent high speculative demand for houses pushed real estate prices through the
roof. The New York Times reported in September 1999 that Fannie Mae (biggest U.S.
underwriter of mortgages) had been under increasing pressure from the Clinton
Administration to expand mortgage loans among low and moderate income people. Banks
issued countless subprime mortgage loans, often floating rate debt, to people with no income,
no job or assets. Mortgages were bundled and securitized on large scale, then sold as Credit
Default Swaps, which were basically securitized mortgages with low risks. CDS were
designed to shift the default risk to a third party and were considered almost riskless.
Government-sponsored companies like Fannie Mae and Freddie Mac labeled CDS’s as near
risk free securities and sold huge amounts to financial institutions, investment funds, hedge
funds and pension funds worldwide. For some time, this was actually a win-win situation:
banks got a higher return on equity from savers, households and companies got more and
cheaper credit, and investment funds and institutional investors got higher returns.
In 2006, reality kicked in and the American real estate market started to deteriorate as
property prices plummeted. The effects for U.S. consumers were desastrous: millions of
subprime debtors experienced payment problems. In a bullish real estate market, subprime
debtors could simple sell their house to pay off their mortgage when they faced payment
problems and even make a profit on the sale. However, in the bearish real estate market, this
bail-out method does not work anymore, simply because property values unavoidably
decrease in the time period between purchase and sale. Many subprime debtors had to cease
payments which undermined CDS prices. In July 2007, investors suddenly lost all confidence
in CDS-back securities and in a wave of mass hysteria, investors and near-bankrupt
investment funds started unwinding positions and dumping their assets on the markets.
21
3.2 The Story of 2008-09
Confidence in the financial system ebbed and credit markets continued to seize up in 2008, a
year characterized by extreme market volatility and unprecedented worldwide government
intervention. Bear Stearns, one of the largest global investment banks and brokerage firms,
collapsed in March 2008 and was sold for peanuts to JPMorgan Chase. In September 2008,
the financial crisis deepened as global equity markets crashed and numerous financial
institutions and companies went bust. Lehman Brothers filed for Chapter 11 bankruptcy
protection and was hereby responsible for the largest bankruptcy in the history of the United
States. Lehman Brothers controlled approximately 5% of global prime brokerage business at
that time. Barclays agreed to purchase Lehman Brothers’ North-American activities, while
Merrill Lynch was sold to Bank of America.
September 2008 was also the scenery of an unprecendented wave of government intervention,
as the United States federal government bailed out AIG, Fannie Mae and Freddie Mac, while
Icelandic banks were nationalized and our national pride Fortis faced partial nationalization.
In the same month, the ‘investment bank era’ ended as Goldman Sachs and Morgan Stanley
became regular commercial banks. The U.S. government passed the Emergency Economic
Stabilization Act in October, which is commonly referred to as a bailout of the U.S. financial
system. The law authorized the Treasury department to spend up to $700 billion for
purchasing mortgage-backed securities and other distressed assets. Meanwhile, governments
worldwide implemented restrictions on short-selling and central banks started cutting interest
rates in an attempt to calm down the financial markets. In December, the largest investor
fraud ever was revealed as Bernard Madoff was arrested and accused of running an alleged
Ponzi scheme.
3.3 Hedge Fund Performance in 2008-09
The hedge fund industry had been spared throughout 2007, but the financial turmoil that
started in the summer of 2008 had a serious impact on hedge funds. Figure 4 on the next page
shows the cumulative returns of the HFRI Hedge Fund Index with two equity market
benchmarks, namely the MSCI World Index and the S&P 500 Composite Index.
22
Figure 4: Cumulative returns, index July 2007 = 100 (July 2007 – Dec. 2008)
50
60
70
80
90
100
110
Jul 2007 Nov 2007 Mar 2008 Jul 2008 Nov 2008
M S C I W o rld S & P 5 0 0 H ed ge F und Ind ex
S o urc e s : H e d ge F und R e se a rc h Inc . & Tho mso n D a ta s tre a m
The negative effect of the Lehman Brothers bankruptcy on the overall hedge fund industry
was mitigated by the fact that many hedge funds had started with prime broker diversification
after Bear Stearns collapsed (Credit Suisse Tremont Hedge Index LLC, 2009). Smaller hedge
funds that relied on only a few brokers were hit harder, resulting in significant losses for
hedge fund strategies with a large percentage of smaller funds. Convertible Arbitrage funds
were seriously affected by the global bans on short selling, but the overall impact on hedge
fund performance was limited because the measures were often of a temporary nature and
were only applied on new positions in the market. Government intervention provided
liquidity, especially for asset-backed securities, and could help to improve market conditions.
A possible investment shift from government bonds to asset-backed securities would create
new opportunities for the Relative Value hedge funds. The multi-billion dollar Madoff
scandal affected some individual hedge funds whose assets were managed by Madoff
Investment Securities. The scandal will also have an impact on all hedge funds, as it will most
likely lead to increased regulation for the entire industry in the nearby future, which could
boost investor confidence and help to end the industry’s asset outflows after it lost 29% ($582
billion) of its assets in 2008. The elevated market volatility had a de-leveraging effect on
many hedge funds and the unwinding of positions was reinforced by more restrictive lending
and higher borrowing costs because of the banking crisis (Strömqvist, 2009).
23
Figure 5: Cumulative Returns of Best & Worst Performing Strategies (Jul ’07 – April ’09)
-50
-40
-30
-20
-10
0
10
20
30
40
Jul 2007 Oct 2007 Jan 2008 Apr 2008 Jul 2008 Oct 2008 Jan 2009 Apr 2009
Convertible ArbitrageCS|T Hedge Fund Index
Dedicated ShortEmerging Markets
Equity Market NeutralManaged Futures
Source: Credit Suisse Tremont Hedge Fund Indices
Figure 5 presents the performance of winners and losers of the hedge fund industry in 2008.
Despite the bad performance of hedge funds as an asset class, there were still some strategies
that consistently performed well in 2008: Managed Futures, a sector that typically performs
well in bearish markets, generated an annual return of 18.33% and the Dedicated Short Bias
strategy generated an annual return of 14.87%. Managed Futures funds benefited from their
short positions in commodity and equity, and long positions in treasury bonds and US dollar
trades. Dedicated Short funds benefited from the sharp equity market downturn. However,
these two winners make up less than 5% of the hedge fund industry, the positive effect is
therefore not noticeable in the Broad Index (CS|T Hedge Index, 2009). The hedge fund
strategies that got hit hard included Convertible Arbitrage, Emerging Markets and Equity
Market Neutral. Emerging Markets funds (annual return -30.41%) generated strong negative
returns as a result of the strong US dollar and decreasing commodity prices. Convertible
Arbitrage funds (annual return -31.59%) were significantly affected worldwide by the
restrictions on the short-selling of equity.
Equity Market Neutral funds are the last in the list of losing sectors, which quite frankly
comes as a surprise. Their losses were almost exclusively caused by the Madoff scandal, as
several large Equity Market Neutral funds had their assets managed by Madoff Investment
Securities (CS|T Hedge Index, 2009).
24
3.4 The Role of Hedge Funds in 2008-09
It is really hard to say something meaningful about the role of hedge funds in the ongoing
financial turmoil, as they are not exchange traded funds. Only monthly returns reported by
hedge fund managers are available and Managers will not always report results honestly. One
can not even be sure whether a hedge fund manager actually employs the strategy that he
claims to employ. Also, nowadays equity markets can lose half of their total value in less than
a month. All these problems make monthly data pretty useless for analyzing causality. It is
impossible to say something about causality using regression analysis: we can not say whether
the plummeting equity markets pulled hedge funds down or vice versa.
We can start by wondering whether hedge funds are capable of threatening global financial
stability. Despite the exponential growth of the industry, hedge funds still only account for a
small fraction of total managed capital compared to mutual funds and pension funds. Major
market movements like in September/October 2008 are thus only possible when several types
of investors follow the same market trends. In December 2007, the largest hedge fund in the
world was JPMorgan Asset Management. Its managed capital at that time was only 2% of the
capital managed by Barclays Global Investors, the largest mutual fund in the world. Its
reasonable to assume that hedge funds can only have a limited influence on financial markets.
The strongest argument for the claim that the hedge fund industry did not drive the ongoing
financial crisis is the fact that it performed bad in 2008 (Strömqvist, 2009).
Fig. 6: "et Asset Value of Fund strategies for 2000-09 (Index Jan 1994 = 100)
0
100
200
300
400
500
600
700
Jan 2000 Jan 2002 Jan 2004 Jan 2006 Jan 2008
Emerging Markets
L/S Equity
Global Macro
All Hedge Funds
Source: Credit Suisse/Tremont Hedge Fund Indices
25
As you can see in Figure 6, net asset value of hedge funds started to decrease rapidly in 2008.
However, the fact that hedge funds have been affected by the financial crisis does not
necessarily rule out that they played an important role in the development of the banking
crisis. For example, the Bear Stearn funds were funds that had provided liquidity for the
complex credit instruments prior to their demise. Also, Bear Stearns collapsed because of
panic following massive short-sales and put option purchases in the days before the stock’s
price crashed. This could have been the work of one or more hedge funds with bad intentions,
because few other market players would be able to hide involvement: the lack of regulation in
the hedge fund industry is to blame for this loophole.
3.5 Systematic Risk During the Financial Crisis
It is only possible to say something about the role of hedge funds in the current financial crisis
if we can say something about their market exposure. According to a report issued by the
International Swaps and Derivatives Association (ISDA) in September 2006, the global
notional value of credit derivatives outstanding increased with 52% in the first 6 months of
2006 to an estimated $26 trillion. Hennessee Group LLC, an adviser to hedge fund investors,
noted in October 2006 that hedge funds had increased their exposure to credit derivatives and
it expressed concerns about the fact that many funds were inexperienced within the
derivatives markets. Hennessee also noted that the use of credit default swaps (CDS) had
become widespread in the early 2000s, by credit-oriented hedge funds and also increasingly
by long/short equity funds. Credit derivatives were the perfect instrument for a hedge fund to
lower the credit risk in its portfolio, however Hennessee was convinced that hedge funds
seriously under-priced credit risk (Hennessee Group, 2006).
The market adjusted model from the previous chapter was re-estimated but now for a 12-
month moving window for the period between January 2006 and December 2008. Figure 7
and 8 show estimation results of the 12-month rolling alpha and beta of the excess returns
(over risk free rate) for the hedge fund industry and funds of funds. The market adjusted
model estimation results showed that hedge funds have generated a significant positive alpha
between 1994 and 2008. Figure 7 shows that hedge funds managed to generate a significant
positive alpha throughout 2006 and 2007, but by early 2008 the industry’s alpha became
negative. The alpha rose briefly became positive again in September 2008, as hedge funds did
not experience a decline that was as strong as the equity market decline. However, it became
negative again in the last months of 2008.
26
Fig. 7: Rolling 12-m Alpha and Beta of Hedge Fund Excess Monthly Returns (2006-08)
-0.8
-0.4
0.0
0.4
0.8
1.2
Jan 2006 Jul 2006 Jan 2007 Jul 2007 Jan 2008 Jul 2008
Alpha Hedge Funds Beta Hedge Funds
Source: Hedge Fund Research Inc.
Fig. 8: Rolling 12-m Alpha and Beta of Fund of Funds Excess Monthly Returns (2006-08)
-1.2
-0.8
-0.4
0.0
0.4
0.8
1.2
Jan 2006 Jul 2006 Jan 2007 Jul 2007 Jan 2008 Jul 2008
Alpha Funds of Funds Beta Funds of Funds
Source: Hedge Fund Research Inc.
The hedge fund industry’s beta, a measure of the sensitivity of the industry’s returns to equity
market returns, the systematic risk, was 0.35 on average and remained fairly stabile between
2006 and 2008. Fund of Funds also generated a positive significant alpha between 1994 and
2008, however the alpha was significantly smaller than the alpha generated by the hedge fund
industry. The alpha of Funds of Funds reached a minimum in May 2006 of -0.8, as certain
strategies performed very bad in that month because of falling prices of stocks, oil and metals
(Bloomberg News, 2006). The bad performance in May 2006 can also explain the decreasing
27
beta in Figure 7: most likely hedge funds got more cautious after the losses suffered and
responded by lowering their market exposure. Apart from the negative alpha in May 2006,
funds of funds generated a significant positive alpha untill early 2008. However, as the crisis
continued to create turmoil on financial markets, the alpha became negative in March 2008
and kept on decreasing untill the end of the year. The Fund of Funds alpha reached a
minimum in December 2008 of -0.6. The beta of Funds of Funds also decreased in May 2006,
as with the hedge funds’ beta in Figure 7, remaining fairly low untill May 2007, when the beta
started increasing. Market exposure tripled between May 2007 and August 2007, right around
the period when the subprime mortgage crisis surfaced and the TED-spread (spread between
the short-term LIBOR rate and return on a ‘riskless’ Treasury Bill) skyrocketed. The beta of
funds of funds stabilized at the level of August 2007 (0.55) untill the end of 2008, when it
slightly decreased to 0.3.
Figure 9 to 12 show estimations of the 12-month rolling alpha and beta of the excess returns
(over risk free rate) of four hedge fund strategies: Emerging Markets, Equity Market Neutral,
Equity Long/Short and Global Macro. Emerging Markets funds were able to generate a
positive significant alpha (except for May 2006) up untill the end of 2007. The alpha was
even exceptionally high in the second half of 2007, but by early 2008 the alpha started
decreasing rapidly. The alpha of Emerging Markets became negative in the middle of 2008
and kept decreasing untill it reached -1 in December 2008. The beta in the beginning of the
period was around 0.6, reached a maximum of 1.2 in May 2006 but quickly decreased to 0.4.
This level was maintainted untill July 2007, after which the market exposure slightly
increased and stayed stabile around 0.5 untill the end of 2008. The alpha and beta of Equity
Market Neutral funds in Figure 10 are much more volatile than those of Emerging Markets.
Equity Market Neutral funds were able to generate a positive alpha up untill July 2007 (except
for May 2006). The alpha kept decreasing between July 2007 and March 2008, when it
reached a level of -0.5, but it recovered in the second half of 2008. The alpha became positive
again during the banking crisis and reached 0.45 in November 2008.
28
Fig. 9: Rolling 12-m Alpha and Beta of Emerging Markets Excess Returns (2006-08)
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
Jan 2006 Jul 2006 Jan 2007 Jul 2007 Jan 2008 Jul 2008
Alpha Emerging Markets Funds Beta Emerging Markets Funds
Source: Hedge Fund Research Inc.
Fig. 10: Rolling 12-m Alpha and Beta Equity Market "eutral Excess Returns (2006-08)
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
Jan 2006 Jul 2006 Jan 2007 Jul 2007 Jan 2008 Jul 2008
Alpha Equity Market Neutral Beta Equity Market Neutral
Source: Hedge Fund Researc Inc
The next month the Madoff scandal erupted and some important Equity Market Neutral funds
had money that was managed by Madoff’s company. Consequently, the alpha decreased
rapidly in December 2008. Looking at the beta in Figure 10, it is obvious that Equity Market
Neutral funds were all but market neutral between 2006 and 2008. The beta was very high in
May 2006, after which it rapidly decreased to 0.1. Equity Market Neutral funds managed to
maintain this level but the market exposure suddenly increased again in May and June 2007,
to 0.4. It was only by October 2008 that the beta of Equity Market Neutral decreased,
29
reaching 0.2 by December 2008. Figure 11 shows the rolling 12-month alpha and beta of
monthly excess returns of Equity Long/Short funds between 2006 and 2008.
Fig. 11: Rolling 12-m Alpha and Beta Equity L/S Excess Returns (2006-08)
-0.8
-0.4
0.0
0.4
0.8
1.2
Jan 2006 Jul 2006 Jan 2007 Jul 2007 Jan 2008 Jul 2008
Alpha Equity Long/Short Beta Long/Short
Source: Hedge Fund Research Inc.
The evolution of the Equity L/S alpha is similar to the alpha of Funds of Funds in Figure 8:
high in the first months of 2006 and decreasing sharply in May 2006, after which it quickly
recovers. Between June 2006 and December 2008, the alpha decreases at a fairly constant
rate, from 1 to -0.7. The evolution of the beta of Equity Long/Short is also similar to the
evolution of the Fund of Funds’ beta. Figure 12 shows the alpha and beta for the monthly
excess returns of Global Macro funds and clearly shows how well this strategy has performed
during the financial crisis. The alpha dropped from 0.5 to -0.75 between April and May 2006,
but the next month the alpha had increased back to 0.7. During the rest of the 2.5 years of the
period, Global Macro funds managed to generate a positive or slightly negative alpha. It is
remarkable that the worser the situation on the financial markets, the better Global Macro
funds performed. Global Macro funds experienced a significant decrease from 0.7 to 0.3
during the banking crisis in September 2008 but the next month the alpha rose sharply again,
ending at 0.5 in December 2008. The beta was 0.5 in January 2006 and increased rapidly in
May 2006. By June the beta of Global Macro funds had dropped to 0.25 and this level was
maintained untill June 2007, when the beta increased to 0.5. The beta remained stabile at this
level but started to decrease slowly in the first months of 2008, reaching 0.1 in December
2008.
30
Figure 12: Rolling 12-m Alpha and Beta Global Macro Excess Returns (2006-08)
-1.0
-0.5
0.0
0.5
1.0
Jan 2006 Jul 2006 Jan 2007 Jul 2007 Jan 2008 Jul 2008
Alpha Global Macro Beta Global Macro
Source: Hedge Fund Research Inc.
When looking at the previous six graphs, the same pattern can be observed: a high beta before
May 2006, a sharp decline during May 2006, a stabile period untill May/June 2007. Around
the time that the subprime crisis struck the financial markets, the beta of most hedge funds
increased slightly and then decreased slowly in the final 1.5 years. Most hedge funds were
clearly affected by the industry crisis in May 2006: Hedge Fund Research Inc. and Bloomberg
News reported that hedge funds showed the worst performance in this month since the
Dotcom crisis in 2000.
So it looks like most hedge funds responded by lowering their market exposure in the second
half of 2006 and the first half of 2007. It was almost impossible not to be affected by the
subprime crisis but overall it seems that the decrease of market exposure prior to the crisis is
the factor that made it possible for hedge funds to limit their losses in this period. However,
we know from Hennessee Group (2006) that Credit Arbitrage and Equity Long/Short funds
increased their exposure to credit derivatives in the first half of 2006. So it seems that these
hedge funds responded to the losses of May 2006 by lowering exposure to equity and
increasing exposure to credit default swaps and similar securities, that were considered more
safe at that time. This is very clear from the evolution of the beta of Equity Long/Short funds
in Figure 11: once the subprime crisis started mid 2007, these strategies paid the price for
their increased exposure to credit derivatives when their market exposure almost tripled
between May and August 2007 from 0.2 to 0.5.
31
So most of the hedge funds took the right decision when lowering their market exposure, but
certain strategies like Credit Arbitrage and Equity Long/Short chose the worst possible
securities to lower their market exposure. However, by looking at the beta for the whole
hedge fund industry in Figure 7, it can be concluded that the negative effects of the wrong
decisions made by a few strategies were not strong enough to drag the entire hedge fund
industry down. The beta of the industry slightly increased when the subprime crisis started but
by early 2008 the beta was lower and kept decreasing throughout 2008.
Keeping this in mind, it is hard to find support for the hypothesis that the hedge fund industry
would have been responsible for the steep decline of the financial markets. One might even
say that by limiting their market exposure prior to the outbreak of the subprime mortgage
crisis, hedge funds probably even confined the market downfall in some way. If hedge funds
had not lowered their market exposure, then the global financial crash might have been even
more extreme. If Credit Arbitrage and Equity Long/Short had not turned to credit derivatives
in 2006 to lower market exposure, the hedge fund industry would have performed even better
relative to the market.
32
4. Conclusion
Empirical analysis of monthly hedge fund index data indicates that the crisis has had a bigger
impact on hedge funds than vice versa. Hedge funds saw almost one third of their assets
disappear and performance in 2008 was the worst in recent hedge fund history (since 1994).
In the past 2 years, media often deemed hedge funds responsible for the major downturn in
financial markets by stating that the industry had taken too much risks. The results in this
paper present a different story: hedge funds took measures after the bad performance in May
2006 and lowered their market exposure. Despite the fact that some hedge fund strategies
sought refuge in credit derivatives, the industry’s systematic risk drastically decreased prior to
the subprime mortgage crisis that started mid 2007. We can only guess what would have
happened if the hedge fund industry had not taken these measures after May 2006. Maybe
they would have suffered more severe losses, this could have pushed financial markets even
deeper when the subprime crisis and the banking crisis in the fall of 2008 started.
No evidence is found that the hedge fund industry bear more responsability for the global
financial turmoil than other institutional investors and financial institutions. However, the fact
that hedge funds have been affected by the financial crisis does not necessarily rule out that
they played an important role in the development of the banking crisis. The herd behavior and
panic on the financial markets could easily have been exploited by individual hedge funds or
groups of hedge funds, for example by naked short-selling and phantom stock scams.
However, it would be wrong to judge the hedge fund industry based on alleged wrongdoings
of individual funds.
33
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1994-2
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1994-9
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2000-0
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1994-2
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1994-2
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1994-2
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1994-2
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1994-2
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1994-2
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1994-9
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1994-9
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2000-0
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