Hedgeweek: What will happen to the hedge fund industry if we experience a 2008-type market decline?

01 December 2014

With interest rates and credit spreads near historic lows and equity valuation above historical averages, many people are concerned that the Federal Reserve, by artificially keeping rates low, has created an asset bubble in the capital markets where many securities are priced to perfection.

What happens to the financial markets when the Fed begins to raise interest rates or there is some other economic shock to the financial system, and what impact will this have on the hedge fund industry? We recently saw a glimpse of this from mid-September to mid-October when we experienced a slight tremor in the capital markets which saw asset prices decline and volatility spike. This was followed by an onslaught of negative articles from the mainstream media relative to the hedge fund industry. Agecroft Partners believes there is a low probability of another 2008 type market selloff in the near future. The hedge fund industry is structurally much more stable today than in 2008.

• The make-up of the hedge fund investor base is very different from 2008. Pension funds over the past six years have been responsible for a significant percentage of positive net flows to the hedge fund industry. These institutional investors are more long term oriented and stable. This trend could be enhanced by a market decline as pension funds strive to reduce their unfunded liability by enhancing returns and reducing downside volatility.


• Endowments and foundations, which were criticised for their redemptions after the 2008 market correction, have repositioned their portfolios to better withstand “liquidity” events. These liquidity issues were primarily driven by the private equity portion of their portfolios, where common practice was to over allocate to private equity in order to maintain a targeted allocation. The fund of funds market place is much more stable. These organisations are using less leverage and their investors are better educated on what they are buying.


• Significantly less leverage utilised by hedge fund investors and managers. In addition, the average leverage used by individual hedge funds has declined, which should help their performance in a down market and reduce the amount of withdrawals.


• Better alignment of liquidity terms and underlying investments. Back in 2008, there was less regard for the mismatch in liquidity terms of a fund and its underlying investments. It did not matter if the fund strategy focused on asset based lending, distressed debt, or some other type of illiquid investment as long as the fund allowed for monthly or quarterly liquidity.


• Lower probability of another Madoff. The Bernie Madoff fraud caused a ripple effect throughout the industry which led to massive redemptions from investors in fund of funds that had Madoff exposure. It also temporarily reduced investors’ confidence in the hedge fund industry, leading to further redemptions and reductions in allocations.


• Lack of good investment alternatives. Contrary to mainstream media reports of investors giving up on hedge funds, the recent spike in volatility of the capital markets has not led to large redemptions. Investors obviously don’t want to increase their equity holdings if they expect a major decline in the equity markets. Once the market actually does sell off, investors’ emotional response is the market can always go lower, which again makes hedge funds look attractive.

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