A variety of euphemisms are often used to describe hedge funds that close their doors from “going under,” to “collapsed,” to “failures,” to “forced into liquidation.” While colorful imagery is engaging, the reality is actually much more boring. As we have written before, most hedge funds that cease operations do so by simply sailing off into the sunset, not going down in a blaze of glory.
A new academic paper (earlier version here) makes this point in spades. Jung-Min Kim of Ohio State University studied hundreds of now-defunct hedge funds and found that most of them closed their doors after a relentless period of poor performance and bleeding assets, not as the result of a sudden violent drawdown as is often assumed. In his words:
“By plotting how the average performance and fund flow of failed funds evolve over time until they fail, I show that, on average, hedge funds fail slowly due to gradual fund outflows following poor performance.”
Kim goes on to call this approach the “slow hedge fund failure model.” It looks like this…
This chart shows the average monthly returns and asset flows for the final 24 months before hedge funds liquidate. (Click on the chart for a closer look.)
There are three (3) sets of returns and asset flows depicted in the chart above. The first two lines are the returns and asset flows of Kim’s entire sample of defunct funds. The next two lines show the returns and flows of assets with no lock-ups (around 20% of all defunct funds). This removes the issue of whether a lock-up was somehow responsible for maintaining assets (and to some extent returns) artificially high.
The final two lines described in the chart legend show the returns and asset flows for defunct funds that closed in a month other than their fiscal year-end month (around 85% of all defunct funds). This removes what you might call more orderly closures where managers gave up right at year-end in order to collect one final performance fee cheque.
Regardless of the sub-sample examined, the conclusion is clear: the average defunct hedge fund did not blow up all at once, but instead suffered a slow and painful death.
So what are the mechanisms that lead to the ultimate demise of these funds? Kim suggests a number of possibilities ranging from style drift to “investor impatience” to simply becoming too small to operate profitably.
Kim describes the first of these factors in the following way:
“As a hedge fund becomes concerned that investors are likely to withdraw capital due to poor performance, it may be forced to change its investment policy. In particular, it has to take more positions in liquid assets so that it can meet redemption requests and it has to avoid trades that could lead to sharp losses in the short-term that would accelerate withdrawals. To become more liquid, a fund may have to liquidate some illiquid positions, which can be costly and hence reduce its performance.”
Funds in the sunsets of their lives not only face the need to prepare for their probable impending demises, but they must also deal with an increasingly impatient investor base. In fact, Kim finds that “investor impatience” (defined as “measured by the time distance between the month in which a fund achieves its maximum value and current month.”) is a good predictor of a fund closing its doors.
Whether fund management economics, (forced) style drift, or impatient investors is the mechanism behind a fund closer, the conclusion is that hedge fund flame-outs are not actually the norm. Instead, most old hedge funds just drift off into the sunset.