Hedge Funds and Systemic Risk - Conclusion (III)

This is my final installment on this paper. I wanted to lift something out of The Hartford's 2006 10K:


"Limited partnerships increased by $363 or 84% during 2006. HIMCO believes investing in limited partnerships provides an opportunity to diversify its portfolio and earn above average returns over the long-term. However, significant price volatility can exist quarter to quarter. Prior to investing, HIMCO performs an extensive due diligence process which attempts to identify funds that have above average return potential and managers with proven track records for results, many of which utilize sophisticated risk management techniques. Due to capital requirements, HIMCO closely monitors the impact of these investments in relationship to the overall investment portfolio and the consolidated balance sheet. HIMCO does not expect investments in limited partnerships to exceed 3% of the fair value of Life’s investment portfolio excluding trading securities.

The following table summarizes Life’s limited partnerships as of December 31, 2006 and 2005.

Composition of Limited Partnerships
		2006								2005
		Amount				Percent				Amount				Percent
Hedge funds [1]		$	427				53.8	%		$	127				29.5	%
Private equity funds [2]			211				26.6	%			179				41.5	%
Mortgage and real estate funds [3]			46				5.8	%			6				1.4	%
Mezzanine debt funds [4]			110				13.8	%			119				27.6	%
Total		$	794				100.0	%		$	431				100.0	%

[1]		Hedge funds include investments in funds of funds as well as direct funds. The hedge funds of funds invest in approximately 40 to 90 different hedge funds within a variety of investment styles. Examples of hedge fund strategies include long/short equity or credit, event driven strategies and structured credit.
[2]		Private equity funds consist of investments in funds whose assets typically consist of a diversified pool of investments in small non-public businesses with high growth potential.
[3]		Mortgage and real estate funds consist of investments in funds whose assets consist of mortgage loans, participations in mortgage loans, mezzanine loans or other notes which may be below investment grade credit quality as well as equity real estate.

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The point of the paper is that it is particularly this inter-relatedness that poses risk. Rather than try to paraphrase the authors, I'm going to include their Current Outlook lifted directly from pages 81, 83)
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The Current Outlook

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., counter-
party 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.
However, based on the analytics developed in this study, there are a few tentative inferences
that we can draw.

1. The hedge-fund industry has grown tremendously over the last few years, fueled by the
demand for higher returns in the face of stock-market declines and mounting pension-
fund liabilities. These massive fund inflows have had a material impact on hedge-fund
returns and risks in recent years, as evidenced by changes in correlations, reduced
performance, and increased illiquidity as measured by the weighted autocorrelation.

2. Mean and median liquidation probabilities for hedge funds have increased in 2004,
based on logit estimates that link several factors to the liquidation probability of a
given hedge fund, including past performance, assets under management, fund
ows, and age. In particular, our estimates imply that the average liquidation probability for funds in 2004 is over 11%, which is higher than the historical unconditional attrition
rate of 8.8%. A higher attrition rate is not surprising for a rapidly growing industry, but
it may foreshadow potential instabilities that can be triggered by seemingly innocuous
market events.

3. The banking sector is exposed to hedge-fund risks, especially smaller institutions, but
the largest banks are also exposed through proprietary trading activities, credit arrangements and structured products, and prime brokerage services.

4. The risks facing hedge funds are nonlinear and more complex than those facing traditional asset classes. Because of the dynamic nature of hedge-fund investment strategies, and the impact of fund inflows on leverage and performance, hedge-fund risk models require more sophisticated analytics, and more sophisticated users.

5. The sum of our regime-switching models' high-volatility or low-mean state probabilities is one proxy for the aggregate level of distress in the hedge-fund sector. Recent measurements suggest that we may be entering a challenging period. This, coupled with the recent uptrend in the weighted autocorrelation , and the increased mean and median liquidation probabilities for hedge funds in 2004 from our logit model implies that systemic risk is increasing.

We hasten to qualify our tentative conclusions by emphasizing the speculative nature of
these inferences, and hope that our analysis spurs additional research and data collection to
refine both the analytics and the empirical measurement of systemic risk in the hedge-fund
industry. As with all risk management challenges, we should hope for the best, and prepare
for the worst.
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I hope that my objective of creating awareness without insanity has been met. Keep your eyes and ears open for exposures, particularly if you have a DNA quirk that has you nosing around 10-K's of financial institutions. Keep in mind the example of HIG.

Thank you for reading this and your comments (both public and private) on the material. Because I wrote (regurgitated) this information, it forced me to wrestle with concepts that were both foreign and complex. Nevertheless, I understand the risk--so if we ever have a meltdown, you can say, "Yes, I've read about those auto-correlations and this event is not a surprise to me."