With the fall 2008 economic crisis, word on the street and in congressional chambers placed a good share of the blame at the feet of hedge funds — specifically, short-selling practices by fund managers and forced deleveraging by lenders. These accusations prompted calls for greater transparency and heavier regulation of these huge multibillion dollar funds. However, without objective data, legislators could either under- or overregulate certain players in the market while missing opportunities to make substantive changes where they may be needed more.
Before we create new regulations targeting hedge funds, said professor Gregory Brown, Sarah Graham Kenan Distinguished Scholar and finance professor at UNC’s Kenan-Flagler Business School, we need to know if short selling and deleveraging were part of the problem. “If either of these activities had happened to the extent claimed, then hedge funds would have noticeably outperformed the market through opportunistic short selling and suffered tremendously from deleveraging,” Brown said.
To find out what really happened, Brown decided to study the data. First he collected hedge fund return information from Lipper/Tass, Hedge Fund Research and Bloomberg Hedge Fund databases. The result — a dataset covering more than 5,000 funds from 1994 through 2008. From that large set of information, he took numbers from the 60 months prior to the crash. Then he estimated risk-factor models and used those models to assess risk-adjusted hedge fund returns in the months around the crash in fall 2008.
Brown’s research shows that given the precarious environment in which the markets were operating, short-selling practices did not result in a significant gain for the funds. Indeed, activity stayed pretty even. This suggests that hedge funds did not undertake systematic “bear raids” of financial companies.
As for deleveraging, funds following strategies that typically rely on large amounts of borrowed money did have somewhat lower returns than would be expected during the crisis. However, the returns were equally low for funds that invested with borrowed money and funds that did not. This suggests that forced deleveraging of hedge funds did not cause the subpar performance. Instead, the hedge funds were probably caught up in the downward spiral like most other market participants.
So what does this mean to you and the average Joe? Direct implications are probably limited, since those who invest in hedge funds are either wealthy individuals or are institutional investors such as endowment funds and pensions. Where these findings will matter most is in policymaking discussions occurring at the federal level.
Since the events of 2008, there have been calls for more regulation and greater transparency.
As with most disasters, it’s never one thing that is to blame but a convergence of factors and behaviors that sets events into motion. Brown’s research helps to set the record straight and enables legislators to take an objective view of how to help make the markets healthy and resilient. While not many of us are directly invested in hedge funds, the health of the economy impacts our personal investments and, for many, the assets that will fund retirement.