How Liquidations Hurt Hedge Fund Returns

Hedge funds that fail to hedge against investor withdrawals generate the worst performance, a study finds.

It’s not just pension funds that have to worry about liability risks.

Hedge funds with high exposures to funding level risks “severely underperform” less exposed funds, according to research from the Copenhagen Business School.

“A good hedge fund follows alpha-generating strategies and simultaneously manages the funding risk that arises from the liability side of its balance sheet, that is, the risk of investor withdrawals and unexpected margin calls or increasing haircuts,” wrote PhD candidate Sven Klinger.

“If not managed properly,” he continued, “these funding risks can transform into severe losses because they can force a manager to unwind otherwise profitable positions at an unfavorable early point in time.”

At a time when many institutional investors are pulling out of hedge funds, proper management of liability risk is particularly essential—and failure to manage those risks can lead to a slippery slope, Klinger argued.

“If a fund generates higher losses than expected, investors get concerned about the possibility of unexpected future losses,” he wrote. “These concerns lead a fraction of the investors to withdraw their money from the fund, which, in turn, causes further losses for the bad fund.”

For the study, Klinger analyzed hedge fund returns between January 1994 and May 2015 using data from the TASS hedge fund database. He found that funds with low exposures to common funding shocks earned a monthly risk-adjusted return of 0.5%—while hedge funds taking higher liability risks earned zero risk-adjusted returns.

“Hedge funds that are exposed to more funding risk generate lower returns,” he wrote. “More precisely, hedge funds that generate lower returns when funding conditions deteriorate generate subsequent lower returns.”

These hedge funds also face larger withdrawals than hedge funds with lower exposure to liability risks, Klinger added—though they can temper risks by imposing strict redemption terms on investors.

“Higher risk should correspond to higher (expected) returns,” Klinger concluded. “Although this rule may hold for traded assets, it can be violated for hedge funds… a situation in which more risk-taking indicates less managerial skill.”

Read the full paper, “High Funding Risk, Low Return.”