Monday, April 09, 2007

Hedge Funds and Systemic Risk - HF Profile (II)

In installment II of our look at Hedge Funds and Systemic Risk, (remember, that none of this is my own work, but rather that of the referenced paper). All page numbers refer to the numbered pages. If you are looking at the PDF doc, the PDF page will be higher than the numbered page.

I wanted to provide a bit of a backdrop of hedge funds (HF's). You may not be a qualified investor and may never will be, so HF's funds may never be in your investment horizon. Nevertheless, they are in the same financial arena as you competing for returns. And the whole point of my writing about this is that if they screw up, it can cost you money.

Let's reflect a moment on the basic tenets of the paper.
  • HF's have proliferated;
  • They have a high attrition rates;
  • Risk profiles (due to leverage and investment styles) are unavailable;
  • Operations are not transparent; and
  • Non-correlated dynamic strategies can correlate into phase locking during periods of market stress.
(I hope not annoyingly, but I'm purposefully repeating some of the core concepts of the paper to solidify them and make them relevant to the current installment without your having to keep going back.)

In their paper, the authors started with a population of 4,781 funds using information from 02/1977 - 08/2004 using the TASS data base. This database does NOT include all hedge funds, but rather is the data base that included all of the information they needed. As these guys appear to be professionals, we can trust that they designed their study to minimize underlying bias in the data. In fact, they go to some pains to explain that, but I'll not do it here.

They parsed this population into HF's that were Live as of 08/04, and those that were in the Graveyard as of 08/04. That split was 2920 and 1861, respectively. Due to the data vagaries, one cannot equate that with a failure rate. See attrition rates below. The authors had to go through and design there study in a way that required them to tweak these numbers so that there was appropriate homogeneity in terms of reported returns etc in the study population. Accordingly, the Live list was reduced and the Graveyard was increased.

Here is a graphic (p. 17) of the final study population by investment style. I would urge you to look at the Appendix A of (p. 84) the paper to read about these styles.

The authors note: "it is apparent from these figures that the representation of
investment styles is not evenly distributed, but is concentrated among
four categories: Long/Short Equity (1,415), Fund of Funds (952),
Managed Futures (511), and Event Driven (384). Together, these four
categories account for 71.9% of the funds in the Combined database."

There's another graphic that is telling. Below (Figure 1) are two pie charts--one showing the composition of the Live Funds and Graveyard funds. Click to make larger or refer to the original study on p. 19.

The authors note "databases are roughly comparable, with the exception of two categories: Funds of Funds (24% in the Live and 15% in the Graveyard database), and Managed Futures (7% in the Live and 18% in the Graveyard database). This reflects the current trend in the industry towards funds of funds, and the somewhat slower growth of managed futures funds."

I'm going to gloss over the section that talks about the correlation matrices. There are three points that are worth noting:
  1. In general hedge fund index is not well correlated to the S&P 500 (p. 19)
  2. Correlations among/between investment styles can vary widely (p. 23)
  3. Events such as LTCM can increase correlation--in 1998 10 out of 13 syle-category indexes yielded negative returns. (p. 24)
Remember that non-correlation moving to correlation is a key part of systemic risk. To show just how pervasive and lingering affect an event such as LTCM can have on correlations, I'm going to include the author's table (CTML) here (oval and highlighting are my own):

The authors report some excellent detailed data regarding HF's using the TASS database. To give you a sense of the increase in HF's over the period, I want to share the authors' table with you. Three things to keep in mind while reviewing this table:
  1. these are additions, only.
  2. 2004 is reflective of the study cut off, so I would not use that
  3. Funds exiting the database were not tracked.

Attrition Rates:

It's important to note that the database used (TASS) by the authors does not included all hedge funds--but rather it is a database that contained all of the information that they needed for their study. The point in considering failure rates is that a hedge fund failure could be one of those "events" like LTCM. In fact, as I wrote this and as I considered the blow up in sub-prime mortgage I wondered if that would pose problems for fixed income arbitrage hedge funds. I asked this of R. Nusbaum on his website.

Here's a screen capture of the ANNUAL average attrition rates in the TASS database:

The authors then go on to build a logit model to estimate liquidations based on the mix of investment styles. This analysis is beyond my ability to convey, but the takeaway is that their estimate is over 11% for the 2004 data base which is 25% higher than the average of 8.8% (p. 63). Here's some information from p 15 cited in their literature review.

I hope that you found this installment interesting. In this installment, I hope that I conveyed:
  • The number of hedge funds and the predominant types of investment styles
  • The increase of hedge funds since inception
  • The attrition rates, and how those attrition rates can be affected by events (LTCM and tech bubble), as well as fund performance to include both funds and volatility.
  • How events can affect the correlation of non-correlative styles (though admittedly, I gave just a small slice and did not produce any of the wonderful tables and work that the authors did. If you are statistically inclined, I hope that you will review their work.)


Anonymous said...

I am surprised at the attrition rates. It would be interesting to compare the "half-life" of the average HF to the "half-life" of the average day-trader. If you correct for the amount of risk taken, I would almost bet that the average day-trader lasts longer-after all, he's playing with his own stash and the HF is playing with (as Bill puts it) OPM.


Leisa said...

2nd_ave--Yes, the attrition rates are rather high. I've said several times in different venues that I really don't believe in that hideous term "smart money", particularly when applied to hedge funds. One merely needs to watch the swish of money in and out of stocks based on updgrades and downgrades to know better.

I can look, but I think that the statistics (if there are any credible ones) that I recall on day traders is worse than hedge funds.

Anonymous said...

Leisa interesting paper...

The beginning Capital
Decimation Partners portfolio could be the returns to the infamous Greenspan put. (perhaps you could replicate in your case??;) Since not many recieved such returns it would appear that he could not be completely trusted. Nevertheless when tested he usually came through.

To me the data presented suggest

a) that hedgies of different strategies as a group are not as hedged as they look particularly when asset weighted (out of their 30% sample) nor against the markets in which they operate outside of fat tail events

b) This unhedgedness increases around fat tails

c) Hedgies invest in instruments, markets or use investment strategies which manifest themselves in relatively high returns correlation which increases in and around fat tail events

c) The markets s-term pricing of likely hedgie creditors (guess who) themselves may be engaging in hedgie type leveraged investing strategies is correlated with hedgie returns and market returns

One quibble (from a weak statisticians view) is that it is not clear which of all the indexes used are market weighted and which not e.g. hedge fund index, SP 500 etc, attrition frequencies...CSFB indexes.

An interesting question is how a part of the financial industry whose assets have grown consistently throughout several "systemic crises" can represent a "systemic risk" such as that used to justify Fed actions.

There is in the papers flow I believe a "hedged" position about this. The implications go back to Capital Decimation Partners returns and may explain some of your perplexedness.

Only Macro, Short and Emerging hedgies seem to have taken any hits over the data period. The actual LTCM intervention involved favouring one bidder (who allowed managment to remain) over another set and injecting/promising to inject liquidity.

Mmmm sub prime, hedgie return volatility, exogenous market tests. The leveraged mind bloggles

Leisa said...

Anonymous--your comment certain denotes a far more facile understanding of the material than my own labored and amateur attempt. But there is something about taking the arcane and integrating into the mundane!

The fat-tail risk is indeed a risk that the authors warned. I was most intrigued by their assertion--that current value at risk models (which I know not a thing about) are inadequate.

"Mmmm sub prime, hedgie return volatility, exogenous market tests." I think that there is some potential danger lurking in them there bushes! I truly wish I understood this stuff better. I need a masters in Finance, Economics and Statistics to make sense out of any of this. But I may not know the genus and species of a snake in the bushes, but I at least want to know the danger of one. This paper for me helped me understand better some of the risks even if I'm unable to evaluate it critically.

Thank you for sharing your insights.

Anonymous said...

Leisa, I am tempted to think that their final model was a part of resume for VAR modeling position.

A canary in the mine for the canary in the mine so to speak or the hedgies version of jawboning?

Mundanely, it would appear to me that adequate modeling would indicate that value at risk should be reduced. More arcanely the only way to make that model real would be to permit that value to be reduced.

Anonymous said...

Snakes and ladders

Leisa said...

Anonymous--thanks for the Peterson institute paper "Moral Hazard and the US STock Market: Analyzing the "Greenspan Put"? I have printed it off and plan to read it. I must profess that constants for Brownian motion and other such equational constructs make my head hurt. I do think that I've found at least three phrases that have some coherence.

Anonymous said...


Wiki to the rescue!

Quite scary if we conclude that your headache may be a form of Brownian motion itself! But never mind a cup of tea (or of whatever you fancy) should do the trick. ;)

Popular culture

"In Douglas Adams's The Hitchhiker's Guide to the Galaxy, Brownian motion is used to create (or rather calculate) the Infinite Improbability Drive that powers the spaceship Heart of Gold. The Brownian motion generator is a cup of hot tea."

Leisa said...

I consulted Wiki immediately upon printing the article! I've not read The Hithikers Guide.... I should read it one day before I die. I do have Brian Greene's The Fabric of the Cosmos which I plan to read before my demise.

MarkM said...

"Facile" meaning "superficial" or "facile" meaning "easily arrived at, effortlessly"? ;)

You are doing a lot of heavy lifting here Leisa. Wouldn't it just be easier to adodt EMH as your mantra, plow your monies into indices and plant redbuds instead? :)

Anonymous said...

Hitchhiker's Guide... funny, easy to read but clever. "The Fabric of the Cosmos" I'll wiki and see. Nothing like a bit of spooky action to make the time go by.

Anonymous said...

Facile vs. facile.

Aye, there's a concept. Which comes more easily, the thought or the words?

I'm so hopelessly in the former camp that this is the best I can do.