The European Central Bank published it’s semi-annual “Financial Stability Review” last week and as usual, it contains some interesting observations about the hedge fund industry.

Cautious attitudes of hedge funds “detrimental to the functioning of financial markets”

Some hedge fund critics point to hedge fund “deleveraging” and hedge fund “selling” as enablers, if not the cause, of the recent market downturn.  Although selling off a market neutral portfolio has a net zero impact on markets, many hedge funds are long-bias and therefore it could still be argued that they put downward pressure on prices.  But the corollary of the hedge fund induced market crash is that hedge funds must have also been the ones supporting the market in the good time.  The December ECB report notes that hedge fund redemptions are therefore bad for markets:

“The reduced availability of leverage notwithstanding, such cautious attitudes of hedge fund managers, even if probably justified at a fund level, are detrimental to the functioning of financial markets, since they imply asset sales and deprive markets of their most active participants.”

Reduced hedge fund leverage

Whether it was self-induced or was thrust upon it, there seems to me little question that overall hedge fund leverage has been falling for quite come time.  The two charts below from the CB report show how gross exposure (of long/short funds) and overall leverage (of all funds) have both fallen over the past 18 months.  (click to enlarge)… More…