Swedroe: Hedge Funds Hurt By Volatility

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:

• In addition to investing in stocks, hedge funds trade extensively in the foreign exchange (FX) market.
• Spikes in stock market volatility lead to a persistent increase in FX volatility as well as reduced liquidity in both markets. Similarly, a spike in FX volatility leads to less liquidity in the stock market. Thus, we can conclude that the markets are interconnected. Increased volatility and illiquidity in one market has predictive power in the other market.
• Volatility and illiquidity in FX—the largest and most liquid market—and stock markets are negatively correlated with hedge fund returns. The exception is dedicated short-bias funds, whose returns are positively correlated with stock market volatility—a relationship that is often cited by critics of short-sellers.
• Declines in stock market liquidity can cause contagion in hedge fund returns.
• Hedge funds don’t benefit from increased volatility and increased illiquidity.
• Overall, there is only marginal evidence that hedge fund activity increases illiquidity and volatility in both FX and stock markets. It’s the correlation between hedge fund returns and heightened volatility and illiquidity that leads to the public perception that hedge funds are the cause of the crisis.
• While there is some evidence that equity-neutral hedge funds relying on HFT strategies cause higher volatility, dedicated short-bias funds actually decrease volatility. Short funds drive overvalued securities toward their fundamental value and can help to prevent bubbles. There is no evidence that short-selling destabilizes markets.
• Hedge fund strategies experience an increase in returns following periods of illiquidity because they profit by exploiting trading opportunities during crises, when assets are cheap and liquidity premiums high.
• The public perception that hedge fund activity has a detrimental effect on financial markets is explained by their exposure to risk factors that correlate with volatility and illiquidity.

Wrampelmeyer also drew this important conclusion: Even hedge funds focused on stock markets have significant lower returns following shocks to FX volatility. This finding has significance for evaluating hedge fund performance.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.