Executive Summary
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The loss of liquidity and its impact on hedge fund performance.
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Redemption issues and their impact on future practice.
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Management challenges and sector performance.
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The threat from alternatives to hedge funds.
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How the crash changed the rules of the game.
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The dilemma of a global regulator.
Introduction
Victim Rather than Villain
The hedge fund sector has been vilified by some politicians, both in Europe and in the US, as if it were a significant contributor to the banking collapse and subsequent global recession. In reality, the hedge fund industry was very much a victim of the banks during the latter half of 2008, and there are some significant litigation actions pending, in which hedge funds are suing investment banks for alleged misdealings in their collateralized debt obligation (CDO) products and credit default swap (CDS) transactions.
However, potential misdealings aside, it is clear that the dreadful performance turned in by many hedge funds in 2008 was precipitated not just by stock market and property price collapses, but also by the total loss of liquidity in all risky markets, a direct consequence of the massive deleveraging by banks. At the same time as they were reducing the size of their balance sheets, numerous banks closed or drastically slimmed down their proprietary trading desks, leaving hedge funds with no bidders for any instrument that had any degree of complexity about it.
Adding insult to injury, many banks forcibly withdrew previously agreed lines of credit to hedge funds, forcing any hedge fund manager running a leveraged strategy to liquidate their positions as fast as possible. Finally, their clients, disappointed by the lack of “absolute returns” that they were implicitly promised by the hedge funds, became extremely nervous, and many decided to turn their investments back into cash, even though they often had nowhere to put the cash (as banks themselves posed a risk for any significant cash holding), and had no clear alternative investment strategy in sight.
The Impact of Redemptions
Faced with the perfect storm of poor performance and severe redemption pressure, hedge fund managers were forced to close funds or suspend redemptions, in order to protect values for those investors remaining with the fund. What the sector experienced during 2008, in other words, was less a performance issue, with strategies failing to work, than a bank run caused by their liquidity mismatch. Money that fund managers thought was “sticky money” (i.e., money that would stay with the fund for the medium term, and so give the fund’s investment strategy a chance to work) turned out to be “on demand” money that investors urgently wanted returned to them.
It did not appear to matter, in these circumstances, whether the hedge fund was invested in assets that the investors could expect to be highly liquid, such as equities or government bonds, or whether the fund had a very illiquid strategy, such as asset-based lending, where there was effectively no liquidity or secondary market for those loans. In the latter situation, if a significant proportion of the investors run for the exit at the same time, the fund management has very few options. They can either halt redemptions or run the risk of paying out all of the remaining liquidity at the expense of those opting to stay. Or they can simply liquidate the fund.
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