Hedge funds’ capital structure is vulnerable to market shocks because most of them offer high liquidity to loss-sensitive investors. Moreover, hedge fund managers form expectations about each other based on market prices and investor flows. When industry-wide position liquidations become a distinct risk they will want to exit early, in order to mitigate losses. Under these conditions, market runs arise from fear of runs, not necessarily because of fundamental risk shocks. This is a major source of “endogenous market risk” to popular investment strategies and subsequent price distortions in financial markets, leading to both setbacks and opportunities in arbitrage and relative value trading.

Sangwook Sung, Hoon Cho, and Doojin Ryu (2019), “Market runs of hedge funds during financial crises”, Economics Discussion Paper No. 2019-31, April 30, 2019.

The below are excerpts from the paper. Emphasis and bracketed/cursive text have been added.
The post ties in with the SRSV summaries on endogenous market risk and price distortions.

Funding liquidity risk

“A hedge fund’s capital structure is fragile because…fund investors are highly loss sensitive and easily withdraw capital in response to bad news…The market is subject to negative price shocks and funding liquidity shocks and…investors who invest in funds prudently can request early withdrawal based on their own market views.”

Hedge funds, whose investors are highly sensitive to losses, are vulnerable to funding liquidity risk and thus fund managers are cautious, holding more cash prior to crises…If an exceptionally devastating liquidity shock sweeps the market, fund investors may start to request capital withdrawals from their funds in response to the initial loss…In the worst case, hedge funds collectively exit the market, not because of risk itself, but because of fear, which explains the stock market exodus of hedge funds during the Quant Meltdown of 2007 and Lehman Brothers’ bankruptcy of 2008.”

“Fund withdrawals…explain half of the decline in the equity holdings of hedge funds [during the great financial crisis]…Withdrawal synchronization [has been] the major driver of the massive asset liquidation by hedge funds during the global financial crisis.”

“The probability of market runs…is related to the distribution of funding liquidity shocks… the likelihood of runs rises as both the market exposure of funds and the price sensitivity of trend followers increase…Market runs are more likely to occur in a market where hedge funds hold greater market exposure and uninformed traders have greater sensitivity to past price movement.”

The logic of runs

“Panic-based crises [are] crises that occur just because agents believe they are going to occur, which is the common feature of most crises in several parts of the financial sector…Hedge fund managers, sharing common investors and interacting with each other through market price, sensitively react to other funds’ investment decisions. In this environment, panic-based market runs can arise not because of systematic risk but because of the fear of runs.”

“When fund managers consider the possibility of runs, they optimally hold less market exposure.”

“When…runs are possible…fund managers can also interact with each other by deciding whether to stay, because investors request capital withdrawals in proportion to the number of exiting funds. Therefore, the investment decision of each fund affects the others’ investment returns and obviously affects optimal decisions… when the market regime changes from a normal state (in which runs are impossible) to a bad state (in which runs are possible), fund managers quickly reduce risky asset exposure prior to the occurrence of runs.”

“Fund managers…take into account not only market conditions but also runs by other managers in deciding their own optimal strategy. As more fund managers decide to exit the market, the expected investment returns of the remaining funds diminish faster than their exit investment returns, which could encourage these funds to run…Using a global game method, we show that a unique threshold strategy exists in which, if the liquidity shock is below the threshold, no managers run but, otherwise, all managers run.”

“When fund managers hold a large amount of risky asset, their investment returns are closely related to each other, so funds sensitively respond to each other’s runs, since fund exits deteriorate short-term market returns and stimulate fund withdrawals. In fact, fund exits worsen the investment returns of both staying and exiting, but the remaining funds then become more fragile than exiting funds, since the return of staying is rapidly diminished by short-term market return deterioration and fund withdrawals affect only remaining funds.”

Consequences of runs

“A large body of literature on the limits of arbitrage proposes theoretical explanations for the price divergence caused by the asset fire sales of constrained arbitrageurs.”

If uninformed investors reward and punish in accordance with short-term fund performance, fund managers become myopic, leaving arbitrage opportunities in the market unexploited…arbitrageurs cannot pursue arbitrage profits because of margin constraints on collateralized assets. When arbitrageurs face constraints on collateral, they are limited in their arbitrage positions…fund managers who are subject to liquidity risk reduce their portion of risky assets in preparation of fund runs.”

“By analyzing the types of stocks hedge funds sold off during the crisis, the authors show that high-volatility stocks were more likely to experience fire sales than low-volatility stocks…because high-volatility stocks respond sensitively to price movement and during a market downturn are more likely to experience price drops. In this sense, high-volatility shocks are riskier and are more likely to deteriorate fund asset values than low-volatility stocks are. Hence, high-volatility stocks have a high chance of suffering from synchronized runs by hedge funds.”

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Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds. At present he is head of research and quantitative strategies at Macrosynergy Partners.