How Do Hedge Funds With a Few Big Investors Manage the Risk of Runs?

How Do Hedge Funds With a Few Big Investors Manage the Risk of Runs?

Open-end mutual funds and exchange-traded funds pose more risks when a small number of investors own much of the fund. These funds could receive unexpected requests for large redemptions. A Securities and Exchange Commission rule requires these funds to have liquidity management programs in part to account for this investor concentration risk.

Hedge funds are not covered by this rule, even though they have a more concentrated investor base. Hedge funds often have restrictions on when investors can redeem shares, but they also tend to invest in less liquid assets than mutual funds or exchange-traded funds, which increases the risk they could pose to financial stability during a crisis.

Here’s how the risk works: One big hedge fund investor might need cash and request to redeem shares. During a crisis, a hedge fund lacking the liquidity to meet the request could sell assets at fire-sale prices. Hedge funds often have large overlaps in their portfolios, so a fund selling assets in a fire sale can have a contagious effect. The selloff by one fund can depress asset prices and lead to losses for other funds with similar portfolios. This happened in the quant meltdown of August 2007 — large sell-offs occurred at hedge funds that relied on computer models for their investment strategies.

Despite an absence of such liquidity management rules, hedge funds seem to be taking action to reduce the risk from a concentrated investor base, according to an OFR working paper released today.

The authors find that hedge funds with a concentrated investor base tend to hold more cash and liquid assets. These measures help the funds accommodate large, unexpected outflows. However, the added liquidity means these funds generate significantly lower risk-adjusted returns than hedge funds with more investors.

The findings are informative for policymakers by showing that hedge funds act to mitigate the risk their small investor base can pose to financial stability.

The paper is “Investor Concentration, Flows, and Cash Holdings: Evidence from Hedge Funds,” by Mathias Kruttli of the Federal Reserve, Phillip Monin of the OFR, and Sumudu Watugala of the OFR and Cornell University. The paper uses data that advisers to hedge funds file on the Securities and Exchange Commission’s Form PF. The data are aggregated to maintain the confidentiality of individual advisers’ data.

Stacey Schreft is the Deputy Director for Research and Analysis at the Office of Financial Research.