Swedroe: Hedge Funds Hurt By Volatility

August 29, 2014

Hedge funds don’t necessarily cause volatility, but their returns sure don’t benefit from it.

This blog is the third part of a three-part series this week on problems with hedge funds and private equity—how they’re viewed and how they affect financial markets as a whole. The first part is titled “Nails In The Hedge Fund Coffin.” The second part is titled “Even Stars Knock Hedge Funds.”

Despite extremely poor returns, the growth of the hedge fund industry has been explosive. Assets under management grew from about $50 billion in 1990 to more than $2 trillion by 2007. Today that figure is at an estimated $3 trillion.

It’s believed hedge funds account for almost a third of the average daily stock market volume. Their rapid growth has brought not only controversy, but also increased scrutiny from regulators as well as legislators.

Jan Wrampelmeyer, assistant professor at the Swiss Institute of Banking and Finance at the University of St. Gallen in Switzerland, attempted to shed light on the relationship between hedge funds and markets with his study, “The Joint Dynamics of Hedge Fund Returns, Illiquidity, and Volatility.”

He points out that hedge funds have been credited with providing a number of benefits to the markets, including increased liquidity, improved market efficiency and the ability to hold corporate management accountable.

On the other hand, they have been blamed for high volatility and market crashes. Their secret nature, use of leverage and high-frequency trading (HFT) have added to public concerns.

Wrampelmeyer examined the relationship between market variables and hedge fund returns to determine the impact hedge funds have on markets. Following is a summary of his findings: