Hedge funds have learned lessons from the crisis of 2008

28 October 2015

Hedge funds have learned lessons from the financial crisis of 2008. By maintaining more liquid investments than previously they can more easily absorb setbacks in the future. This is apparent from the research project ‘Liquidity risk and derivative markets: Lessons from the crisis and insights for the future’ of Joost Driessen. He and his group analysed, for example, the response of hedge funds to the collapse of the capital market in the United States. He carried out his research with a Vidi great from the NWO Talent Scheme programme.

Scenes on the stock markeDespair on the stock market in 2008. Photo: Corbis

Following the aftermath of the banking crisis of 2008 there were calls for banks to be obliged to increase their capital buffers. After all these were found to be so limited that slight losses could bring a bank into major difficulties and could even lead to bankruptcy. These new regulated capital requirements have been implemented, although according to analysts they are barely sufficient. Joost Driessen, on the other hand, was interested in the voluntary formation of capital buffers, for example, in the high-risk market of hedge funds.

Hedge funds trade in non-liquid investments – shares and obligations of small companies, derivatives – that cannot always be sold quickly. Hedge funds expect that in economically more favourable times these investments will provide additional profits. However, that makes them very sensitive for unfavourable market conditions or as Joost Driessen puts it: ‘Hedge funds with a lot of non-liquid investments are holding a time bomb in their hands.’ That became apparent in 2008: in the aftermath of the crisis various funds hit the wall.

Larger buffer of liquid investments

Joost Driessen: ‘The more you focus on non-liquid assets that are difficult to sell, the harder it is to respond to unexpected market developments. This vulnerability during unfavourable conditions was apparent in 2008 when hedge funds were obliged to sell quickly for bargain prices in order to meet their current obligations. Our research reveals that hedge funds in the United States have now voluntarily built up a larger buffer of liquid investments. In other words, they have done this without the intervention of financial watchdogs. Consequently they will be more resilient in any future crisis. They have clearly learned lessons from the knocks this sector experienced during the 2008 crisis.’

PhD researcher Ran Xing analysed large American databases in which the investment behaviour of hedge funds is recorded. The data revealed very precisely who owned what and when. Per quarter Xing compared the liquidity of these investments. Hedge funds sold mainly their liquid investments during the crisis but since then they have more than compensated for this and have built up a buffer of liquid investments.

Liquidity premium?

Although in the majority of cases pension funds have less risky investments than hedge funds, pension funds also invest in non-liquid investments, such as private equity funds or infrastructure projects. With this they assume that the non-liquidity of these investments will provide an extra high return in the future, a so-called liquidity premium. Within the same project PhD researcher Patrick Tuijp discovered, however, that in several cases long-term, non-liquid investments only yielded either a small or no liquidity premium whatsoever compared to liquid investments. He discovered this by building a theoretical model based on economic theories. This theory has not yet been tested on actual market data but has been inferred from valid economic laws. Non-liquid investments do not automatically perform better in the longer term than liquid investments, according to the theory.

Source: NWO