According to a recent article in the European Central Bank’s Financial Services Review, hedge fund activities pose considerable risk to the financial system.
According to a recent article in the European Central Bank’s Financial Services Review, hedge fund activities pose considerable risk to the financial system.
The article, in the June edition of the FSR, claims that ‘hedge funds’ largely unconstrained investment strategies’ lead to a risk of ‘adverse effects of disorderly exits from crowded trades’. This is not a view shared by EDHEC.
The article reasons that increasingly similar positions in increasingly illiquid assets lead to a risk in the event of massive redemption of investors’ hedge fund shares. Rising correlation between the returns of different funds and different strategies is taken as proof that these funds hold similar positions. Although the article’s evidence in favour of an increase in correlation is weak, EDHEC believes there are many reasons – other than similar positions – for increasing correlation. Furthermore, the claim of an upward trend in illiquidity exposure is not substantiated. EDHEC argues that mechanisms such as lock-up periods effectively protect hedge funds against a mismatch between asset liquidity and funding liquidity.
According to EDHEC, the FSR article’s conclusion of a risk of ‘disorderly synchronous exits from similar trades’ is based on mere speculation. It should also be noted, says EDHEC, that no study has been able to demonstrate the implication of hedge funds in any systemic crisis so far. Obviously the question of systemic risk is of importance, but EDHEC says it does not dispose of enough data to reliably address this question at this stage. For authorities in the financial markets, EDHEC believes working towards obtaining such data would probably be a worthwhile exercise.
In addition to evaluating systemic risks, EDHEC feels that the benefits offered by hedge funds should not be neglected when analysing the role they play in financial markets. As stressed by the ECB itself in a previous study, ‘hedge funds have a role as providers of diversification and liquidity, and they contribute to the integration and completeness of financial markets’.
