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Hedge Fund Shakeout


It is just as likely that one will implode of its own doing...


Here is an interesting article on systemic risk and hedge funds:


From, NYT, Sunday, Sept. 5, 2005

Included is a 95 page paper published by Andrew Lo, from Uni. of Chicago. The currrent outlook contained the following:

" A definitive assessment of the systemic risks posed by hedge funds requires certain data that is currently unavailable, and is likely 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. Hedge fund industry has grown tremendously fueled by 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 pt*.

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 flows, and age. In particular, 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 flows 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 pt*, and the increased mean and median liquidation probabilities for hedge funds in 2004 from our logit model implies that systemic risk is increasing."

I agreed with many things in this article. Mr. Lo, however, should look at the large dealers that clear (domicile positions and provide leverage) a little more closely for he does not know the beast.

Since the repeal in 1989 of Glass Steagall, banks have become behemoths of risk, merging brokerage, lending, and banking businesses white-washed with leverage themselves. It is possible that when one of these bloated bastions of risk fail, a hedge fund will be the trigger, but it is just as likely that one will implode of its own doing. The weak spot in the system is really a company like JPM who does it all and has trillions of derivative risk to boot.

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