Well recent performance has been good.
Major strategies have on aggregate returned close to 16% to the end of September, which was ahead of equities over the same period. It was a choppy enough period. Many funds had a tough July suffering their worst performance, compared to equities, in 20 years. Swings in AI sentiment, surging bond yields and volatile energy prices have been driving factors in performance.
And there are a lot more investors in hedge funds today. In the last 10 years or so, gross assets have tripled. The IMF estimates that including derivative exposures, notional assets for global hedge funds are in excess of $40 trillion. Their presence is especially notable in bond markets. Hedge funds own over 10% of the US bond market – more than mutual funds do.
For many investors, hedge funds are an alternative to more traditional funds, and they see them as offering diversification or protection, irrespective of the investment cycle.
Hedge funds get a lot of attention from the world’s central banks. In its Regulatory and Supervisory Outlook last February, the Central Bank of Ireland highlighted vulnerabilities around liquidity, leverage, and counterparty exposure in this sector, putting the risks between significant and extreme.
Last week, the IMF produced analysis on hedge funds and especially
how they perform at times of market stress. Investors would do well to note the conclusions.
The IMF’s view is basically that while hedge funds can support market liquidity and efficiency in normal times, they can magnify price moves and liquidity strains during periods of market stress. The distortions they cause when markets face crises are driven by leverage, fragile investor funding and crowded trades.
The IMF research highlights several features that investors should be alert to.
*Equities held by hedge funds tend to get hit harder during market stress than those held in conventional funds. This may be due to unwinding of leverage positions or investor redemptions.
*Crowded positions can unwind rapidly during periods of market stress leading to price declines beyond what fundamentals might suggest. The IMF evidence shows that the stocks most widely held by hedge funds are 10% more volatile and suffer 4% deeper peak-to-trough losses than lesser crowded stocks.
*Hedge funds rely heavily on secured financing and derivatives-based leverage, both of which are highly sensitive to market conditions. Hedge fund leverage is highly pro-cyclical.
*Hedge fund portfolios are becoming increasingly similar. The overlap in equity holdings increased dramatically in recent years especially among the larger funds. This raises the risk of synchronized asset sales which can lead to price distortions.
*Hedge funds tend to be contrarian in calm markets, but when volatility rises and liquidity conditions deteriorate, they are more likely to follow the herd. This is especially the case for smaller hedge funds and those carrying more leverage.
The key message for investors from the IMF research seems to be that the presence of hedge funds can improve market efficiency, liquidity and risk sharing and also play a key role in portfolios in “normal” environments.
But when market conditions deteriorate, the behaviour of hedge funds can change dramatically, and increase portfolio vulnerability just at the time when it is most needed.
