Hedge Fund vs. Bank Blowups | 1 Page Analysis

Hedge Fund Blowups

Hedge Fund Vs. Bank Blowups

Last week a member of a hedge fund professionals networking group on LinkedIn asked a question about why we have seen more investment bank blow ups than hedge funds.

In the past 2 years there have, of course, been hedge fund blow ups starting with Amaranth in September 2006. Unlike troubled investment banks not all hedge funds suffering losses and closing downs receive press coverage. We have seen a few notable names, such as hedge funds managed by Bear Stearns, Sowood, Peloton and a few others mentioned in the papers. Many more troubled hedge funds managed to avoid major headlines. It’s not necessarily clear what exactly constitutes a hedge fund blow up. For the names mentioned above the loss was sudden and quick and resulted in eventual termination of the funds. Amaranth lost close to six billion dollars in just one week. Peloton earned a spectacular return of almost 90% in 2007 just two months before the blow up. These, however, are extreme cases. Many hedge funds suffer the slow death as they enter into periods of large draw downs. In this study we tried to identify hedge funds that have terminated since January 2008.

To analyze the rate of failure among hedge funds this year, we ran the analysis on the universe of hedge funds, fund o funds and CTA that report to Barclay’s Global Data Feeder database. To identify the blown up funds we first looked at the funds that stopped reporting performance to the database. We realize that there may be various reasons why a hedge fund would stop reporting to the database, but we believe that primary reason would be a significant drop in performance. To avoid double counting we focused primarily on the “On Shore” funds reporting performance in United States Dollars. There were 3,998 funds that reported performance at the beginning of the year. Of these funds 366 have not reported their performance since May 31, 2008. Chart 1 shows the distribution of the cumulative return of these funds since January 2007 (or later if the funds launched after January 2007).

Out of the 364 funds -156 funds or (43%) have had negative cumulative performance through their last reported date. Chart 2 shows the distribution of Maximum draw down achieved during the same period.

As we mentioned above we cannot be sure whether or not the funds that stopped reporting to Barclay’s database have indeed blown up. We do, however, consider it likely that hedge funds that stopped reporting after experiencing an extreme drawdown are in a “blow up” situation. Chart 2 shows that almost a third of the funds have experienced a drawdown of 15% or higher. This brings our estimate of defaulted funds to 2.5% or (100 out of 4,000).

Given the current market environment the estimate seems low. One factor that may account for relatively low blow up rate is the hedge fund liquidity. As an asset class, hedge funds enjoy the benefit of providing relatively stable asset base that is protected by long lock ups, strict redemption schedule, and withdrawal fees. Given these restrictions hedge funds that experience large losses are able to survive longer. It’s generally expected that the industry will experience significant redemptions at the end of the year, which may bring to the run on many hedge funds and lead to higher blow up rate. In the future issues of this newsletter we will attempt to examine the factors that may be helpful in identifying potential blow ups.

Guest post by Aleksey Matiychenko of Risk-AL, LLC

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