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Home > Blogs > All About Alpha > Co-investing alongside hedge funds? Could be lucrative, but read this first…

Co-investing alongside hedge funds? Could be lucrative, but read this first…

Liquidity risk | Co-investing alongside hedge funds? Could be lucrative, but read this first… All About Alpha

Hedge funds continue to bear the brunt of blame for the 2008 credit seizure, market collapse and ensuing Great Recession. Whether part of the problem (securitization), an exacerbation of the problem (short-selling) or the problem itself (Madoff), the weight of public opinion continues to be stacked against them.

So it should come as little surprise that a recent academic paper piles additional blame on hedge funds, arguing that liquidity risk in stocks is inherently higher among securities held by institutional players than identical securities held in the portfolios of individual investors and banks.

The paper, entitled Institutional Investors and Liquidity Risk and written by Lubomir Petrasek, Department of Finance, Smeal College of Business at Pennsylvania State University, takes an empirical look at the effects of institutional ownership on liquidity risk in the cross-section of stocks.

Specifically, Petrasek finds a positive relationship between hedge fund ownership and liquidity risk, and a negative relationship between bank ownership and liquidity risk. He also finds that stocks held by hedge funds as marginal investors experience significant negative abnormal returns during liquidity crises, whereas stocks held by banks as marginal investors or by institutional investors such as commercial banks, mutual funds and insurance companies experience significant positive abnormal returns.

“Such evidence would support the hypothesis that ownership by hedge funds affects liquidity risk more than ownership by other types of institutional investors,” he says.

In other words, hedge funds really are the bad guys.

The paper offers additional detail on why this is the case – namely leverage, and the fact that during the 2008 market crisis funding constraints of leveraged speculators like hedge funds led to a greater liquidity risk than other participants like mutual funds and banks, which have “a unique ability to hedge against market-wide liquidity shocks.”

And we thought it was the other way around.

According to Petrasek’s findings, the liquidity risk of stocks is positively and significantly related to the percentage of hedge fund holdings. In other words, daily returns on stocks in which hedge funds are marginal investors are more sensitive to fluctuations in aggregate liquidity than returns on otherwise identical stocks held by individuals or other institutional investors.

The chart below plots the number of institutional investors holding sample shares over the 80 quarters from Q4:1989 through Q3:2009. Institutions are classified as banks, insurance companies, mutual funds, investment advisers, hedge funds, or others. Tick marks correspond to the last quarter of a given year.

Institutional Investors holding sample shares 1989-2009

In contrast, the relationship between the liquidity risk of stocks and bank ownership is negative and significant, suggesting that stocks held by banks as marginal investors are less exposed to liquidity shocks than identical stocks held by individuals or other institutions. The second illustration below provides the time series plot of estimated coefficients from cross-sectional regressions of liquidity betas on bank and hedge fund ownership.

Liquidity risk

His last shot: That stocks owned by hedge funds as marginal investors experience significant negative abnormal returns on crisis days, whereas stocks held by banks as marginal investors experience significant positive abnormal returns.

It is an interesting take on what is now an old tale: that greedy hedge funds levered to the gills took on greater risk when the going was good, and then ran for the hills when they got their margin calls, exacerbating stocks’ declines.

Petrasek admits that despite his research, there is still no clear answer as to why some stocks are more exposed to fluctuations in market liquidity than others.

What he does find is that stocks in which hedge funds are marginal investors have returns that are more sensitive to changes in aggregate liquidity than stocks held by individuals. In contrast, stocks in which commercial banks are marginal investors tend to be less exposed to market liquidity fluctuations.

Hedge fund ownership also has a significantly larger effect on liquidity risk than mutual fund ownership or ownership by other types of institutional investors. Furthermore, the effect of hedge fund ownership on liquidity risk is the most pronounced during liquidity crises.

Many a good hedge fund was left holding an empty bag for no other reason than their investors had no other “ATM” to which to turn. Perhaps that’s why stocks held by hedge funds faced higher volatility. We also know that people a lot smarter than us have argued that hedge funds weren’t to blame for the world’s financial woes. Not in this case.

This guest blog was first published on AllAboutAlpha.com.

Tags: banking , hedge funds , liquidity risk , risk , stocks and shares
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