To say that hedge funds were implicated in the 2008 financial calamity is an understatement.  Many commentators placed the blame squarely on the shoulders of these “unregulated and secretive” asset managers.  Such is life, some hedge funds acknowledged, when you happen to be at the scene of a crime.

A few studies have since debunked the notion that hedge fund selling was the primary driver behind the market downturn of 2008 (see one of them here).  But few have been as exhaustive as a new one by Itzhak Ben-David of Ohio State, Francesco Franzoni of the Swiss Finance Institute, and Rabih Moussawi of Wharton.  The Behavior of Hedge Funds during Liquidity Crises addresses a raft of questions that are surely top of mind for the world’s regulators.  Specifically,

• Did hedge funds actually run for the exits along with everyone else?
• If so, how much and was it enough to actually affect equity prices?
• What kinds of hedge funds were selling?
• What kinds of equities did they sell?
• What motivated them to sell?
• Who bought their positions? and,
• How was performance impacted?

Did hedge funds run for the exits and if so, did they trample anyone?

The trio found that hedge fund (long) equity ownership as a percentage of overall equity markets fell precipitously during the crisis – dispelling the notion that hedge funds bought up what other investors were dumping.

Some might point out that a drop in long positions might be accompanied by an off-setting drop in short positions.  By covering shorts, hedge funds would be buying, not selling.  But the trio finds that overall short interest didn’t seem to move nearly as much as longs – suggesting that the net effect of hedge funds reducing gross exposure was to amplify the market drawdown.

What kinds of hedge funds ran fastest?

It appears as though a sub-set of the biggest hedge funds was mainly to blame for the selling.  These funds were first to the exit door, while many other hedge funds filed out in a relatively calm and orderly manner.  The chart below from the paper shows the typical increase or decrease of equity allocations in a one month period.  As you might guess the typical distribution has a mean of around zero.  But during the 2008 crisis, the mean dropped significantly.  In fact, the number of funds that dumped more than 70% of their equity holdings in Q3 and Q4 2008 rose by over 10-fold.

Apart from a concentration of selling among the biggest sellers, there were a few other interesting trends according to the study.  Event-driven, fixed income arb, global macro, and managed futures reduced their equity holdings the most.  Meanwhile, market neutral strategies actually increased their equity holdings.

What did they sell?

The paper shows that these panicked hedge fund managers tended to dump high volatility stocks during the calamity.  While this may seem like a no-brainer, note that hedge funds tended not to dump high vol stocks during times of overall market volatility (high VIX), but apparently only when liquidity dried up as it did at the end of 2008.

Why did they sell?

It’s easy to blame fund managers for simply being nervous nellies and wanting to retreat to cash when the global markets started to fall out of bed.  But hedge fund investors and prime brokerages apparently deserve some of the blame.

Regular readers may recall a paper by John Dai and Suresh Sundaresan of Capula Investment Management that explicitly modeled investors’ “redemption” option and lenders’ “funding” option.  Ben-David, Franzoni, and Moussawi’s calculations suggest that around half of the hedge fund selling in the second half of 2008 was precipitated by the exercising of these two options (in roughly equal proportions).

Who bought their positions?

Okay.  So if hedge funds were net sellers during the downdraft, then who actually provided the much-heralded liquidity?  This question is apparently a bit tougher to answer.  The paper suggests that company management and retail investors may have filled the void, but this conclusion is not statistically significant.

How was performance impacted?

However, it seems that hedge funds that ran for the exits did better than those that did not.  This may be because the cash generated from equity sales was immediately redeployed in other asset classes.  Write the authors,

“Overall, we view these results as additional support to the hypothesis that multi-asset hedge funds that are familiar with alternative markets (e.g., global macro and futures hedge funds) reallocate equity sales proceeds to those other markets as investment opportunities arise.”

Bottom Line?

Those hoping to pin the blame for 2008 on hedge funds will have to keep looking.  As Ben-David, Franzoni and Moussawi point out…

“The magnitude of the effect [of hedge fund sales] is large: during the worst liquidity crisis in our sample, the crisis of 2008, hedge funds reduce their positions by 18% per quarter, over two quarters. The economic magnitude is smaller when computed as a fraction of market capitalization (about 0.5% per quarter). Although these declines in holdings are material, it is not clear whether they could cause a market-wide liquidity dry-up, at least in the equity market at large.”

Given the market disaster that was 2008, one would expect that any alternative investment firm that dipped its toe into the equity offering market is worse the wear for becoming publicly held.

From London-based and London Stock Exchange-listed Marshall Wace on down to the many littler guys who lined up to list on the Irish exchange and others, both for permanent capital raising and for getting the rubber-stamp approval of being listed, it’s been a kind of given that in hindsight the efforts of going public weren’t really worth it.

Not so, according to a recent paper by Greg Gregoriou, Francois-Serge Lhabitant and Fabrice Rouah entitled “The Survival of Exchange-Listed Hedge Funds.” The paper argues that it was – and still is – more than worth it, if survival and longevity amount to anything. According to their research, the survival rates of exchange-listed alternative investment firms versus non-listed entities are significantly better.

Call it Survivor, hedge-fund style – the ones not voted off the island.

Their reasoning makes sense: Publicly traded firms are required to be more transparent, report information more frequently and most of all, adhere to regulations of exchanges. So while their stock price may make it seem like going public was far from worthwhile, their survival rate is much better than their non-public counterparts because they are following standards, guidelines and practices that private funds, for the most part, aren’t.

Another element: the concept of permanent capital, which we at AllAboutAlpha.com have focused on about from a private equity standpoint, in that a fund manager can put assets to work in long-term strategies without being hampered by cash inflows and outflows.

“This turns the famous dream of ‘permanent capital’ into reality,” according to the report’s authors.

Even after considering factors known to affect survival, such as size and performance, the paper’s conclusion – based on various estimators and models – indicates that listed hedge funds by nature tend to be larger and in turn more adoptive to conservative investment strategies than non-listed funds. Most importantly, the paper finds that the failure rate of listed funds is substantially lower than that of non-listed funds, though only during the first five years of life.

The chart below, which utilizes the Kaplan Meier curve for listed and non-listed funds, illustrates how the survival rate for publicly traded funds is significantly better two to six years out.

We at AllAboutAlpha.com and certainly many others have written about the rise and fall of exchange-listed hedge fund firms – from the go-go days of 2007, when hedge fund firms were tripping over one another to become publicly traded entities, to more recent times when the words ‘hedge fund’ and ‘IPO’ simply did not go together. (Click here for some of AllAboutAlpha.com’s coverage of hedge funds and IPOs.)

And certainly more than a few hedge fund IPOs never made it. Some died before reaching their optimal targeted operating size. Others decided to return assets to shareholders because of widening discounts. Indeed, the biggest challenge of listed hedge funds, according to the paper’s authors, is the potential discount or premium to net asset value (NAV).

During the panic of September-October 2008, for instance, average discounts to NAV surged to 20% from just 1% for hedge funds listed in London.

Still, many funds now have mechanisms that effectively control the discount. This mechanism allows them to invest in their own shares when the discount between NAV and the quoted price becomes large. The funds will then sell their shares at a profit when the discount becomes smaller.

Combine that with the slow crawl out of the deep, dark hole for equity markets around the world and one could potentially envisage a hedge fund IPO market coming back to life – a new dawn on the island, so to speak. Just look at UK fund firm Gartmore’s latest earnings, which suggest they may finally have turned the corner.

Maybe.

Most know that the International Monetary Fund isn’t a bank in the conventional sense – at least in theory, or in the way those who frequent these virtual pages think of them.

Yet headlines and anecdotal evidence over the past few weeks might suggest there is more bank – and even fund-like activity – going on than meets the eye.

First, the IMF comes up with a forecast that commodities prices are going to rise this year – not drastically or in a bubbly kind of way like they did in 2008 but in a grind-higher kind of way, thanks to recovering economic activity and reduced supply.  This, despite already rising significantly during the recent recovery (chart below via IMF Survey magazine)…

Then they announce that they’re dumping a bullion-load of gold into the market – 191.3 tons of gold reserves parked somewhere deep in their Washington DC coffers in a bid to raise cash for lending purposes.

What gives? Has the IMF turned into some sort of hedge fund / CTA-style speculator? Are they talking their own book, so to speak?

Most would strongly suggest otherwise. Contrary to what a broader portion of the news-absorbing public believe, the IMF’s mandate is to help countries in financial trouble out of their mess – with short term loans and with longer-term market-friendly direction and advice that eventually leads to renewed investment and recovery, and in turn growth, employment and reduced poverty.

In fact, the history behind why they have so much gold in the first place makes their mandate make that much more sense, not to mention the organization’s long history of producing reams of research, working papers and forecasts.

Yet in the span of less than six weeks, the IMF, which has 186 member countries, the biggest one being the US, has made public announcements about where it sees commodity prices going: black gold on one side of the coin, and real gold on the other.

Lest anyone forget, the IMF’s sister organization, the World Bank, has its own $65 billion portfolio and an in-house, high-tech, multilingual, proprietary trading floor to manage it.  In fact, the pension money of both the IMF and World Bank is allocated to a broad range of outside hedge funds and other alternative investments.  So the IMF is no stranger to hedge fund strategies.

Is there something else behind the IMF’s recent actions?  Does it have a case of hedge fund envy?

Ironically, the recently unveiled “Volcker Rule,” if ever approved would effectively ban banks from engaging in proprietary trading or even having separate businesses that engage in trading and investment activity would make the kind of stuff the IMF and World Bank are doing effectively illegal. Scoff-worthy, indeed, but not completely beyond the realm, we might suggest.

Indeed, with news like Britain’s long-standing  encounters of the third kind swashing about, one can never be absolutely dead-fast sure about government motivation, intervention, action and what may or may not be real – like the IMF being a hedge fund in disguise, and in turn influencing commodities markets to its benefit.

A candidate for the Volcker rule, or one for the conspiracy bin? We’ll let you be the judge.

By: Ranjan Bhaduri, AllAboutAlpha.com Editorial Board & Sabah Rehman, AlphaMetrix Alternative Investment Advisors

Islamic finance is an industry which has steadily gained attention since its establishment in the late 1970s. It is distinct from conventional finance in its outward adherence to Islamic law (shahria’h).  One such distinction, as provided here, is that it prevents the use of interest, given the notion in Islamic texts that making money from money constitutes usury. Islamic finance is based on the belief that wealth should be created only through legitimate trade and investment in assets. Since the 2008 financial crisis, it has understandably gained in popularity given that it generally forbids both debt trading and excessive risk taking.

The ubiquity of interest-based lending is such that it may seem inconceivable for functioning financial system to forbid it. However, the payment of interest has been condemned by various communities for hundreds, even thousands, of years. The Greek philosopher Aristotle said, “Very much disliked also is the practice of charging interest: and the dislike is fully justified for interest is a yield arising out of money itself, not a product of that for which money was provided. Money was intended to be a means of exchange; interest represents an increase in the money itself. Hence of all ways of getting wealth, this is the most contrary to nature.”

With much the same viewpoint of Aristotle, Islamic finance holds that money itself does not have the quality of growing or lessening; it is an inert thing that acquires value through the merit, talent or labor of someone else. Thus, money is an instrument that can be decreased or increased only by the person who is using it. Interest-based lending is further criticized on the basis that it creates inequity by favoring the rich and running against the interest of the whole society by allowing a small group to attain vast profits.

Islamic finance adopts an alternative to interest-based lending in the form of partnership-based focus: Profit and Loss Sharing (PLS), which allows for the investor and entrepreneur to bring together their capital so that risk and reward can all be shared. PLS is intended to benefit society as a whole, and is executed in Musharakah and Mudarabah. Musharakah involves partners providing funds for a venture, with profits shared according to their invested capital. Consequently, the loss is also taken the same way. Banks partake in this as well, and the bank’s part of the profit is linked to their financial risk. Mudarabah is when one partner gives money and the other party provides his knowledge/talent to invest and manage the project. Then the profit is shared according to a predetermined ratio.

On an international level, Islamic banking units have been launched by some of the largest international banks, including HSBC, Lloyd TSB, and Citibank. The United Kingdom has experienced great growth in the field, with over 20 institutions offering Islamic banking facilities, and more than 2 million people taking advantage of them. Harvard University has also started an Islamic Finance Project to conduct research and analysis aimed at promoting better understanding of the field. It seeks to further dialogue on the subject by conducting Islamic Finance Forums, with prominent players from all over the world participating.

After taking the throne from Malaysia, the U.A.E is currently the Islamic banking hub, but that could soon change, according to an article in Forbes by Lionel Laurent. Cities like Singapore, London, Hong Kong, Bahrain, and Sydney are all eying the sector, hoping to become the center of the Islamic banking world.

London is already regarded as the West’s hub for Islamic banking. It began offering mortgages that were compliant with Islamic law as early as 2003, and it continues to grow as it is now offering Sukuk bonds or Islamic bonds. The Australian Government is also keen on Islamic finance as Trade Minister Simon Crean recently introduced the Government’s first publication on the subject. Crean stated that: “Islamic financing is a crucial plank in the Government’s strategy to make Australia a financial hub in the Asia Pacific region.”

source: Shariah-Fortune.com

While Islamic finance has become increasingly popular worldwide, there remain issues that impede its growth. Corruption and bad investments exist—whether real or perceived—in countries which are among the largest practitioners of Islamic finance, tainting its reputation with risk in the West. Further, varying interpretations of Shahria’h in terms of what is lawful and what is not can cause confusion, regulatory challenges, and difficulties in acceptance.

Nevertheless, Islamic finance is vastly expanding. The current holdings are estimated at around $1 Trillion worldwide. Once Islamic finance finds some uniformity, a better regulation system, and easier ways for universal adoption, it could become a driving force in the world of finance.  As a result, The World Bank announced at the end of 2009 that it plans to try and help uniform Islamic finance by working with Islamic finance industry standard-setting bodies.

The hedge fund industry did not wither and die during the 2008 market collapse and great liquidity crunch.  Despite calls to the contrary, there are still thousands of hedge funds and funds of hedge funds out there, focused on producing decent returns in ways that other types of investment managers simply cannot.

Which brings us to a bit of good news about the state of the hedge fund industry: Investors were already putting money back into both hedge funds and funds of hedge funds in the final quarter of 2009, according to to the latest quarterly survey by Brighton House Associates, released earlier this month. The even better news for hedge fund industry participants: They were putting money into strategies that they felt would be good long-term bets rather than just a way to recover their 2008 losses.

The report, which surveys more than 1300 alternative investment managers every quarter, has become a useful snapshot of what investors are thinking and where their intentions lie in terms of alternative investment allocations.  And the latest report was certainly no let-down.

According to the results global macro and commodities were among the top strategy picks of investors in the final three months of last year – a sign that investors are looking for hedge fund managers focused on trends related to the global economic recovery – and not just any recovery. (see chart highlighting investor strategy interests below.)

Source: Brighton House Associates

Funds taking advantage of opportunities in the secondaries space were also of interest to investors, according to the survey results, as were funds of hedge of funds, which after suffering from additional outflows through the first half of last year finally began to level off and recover.  Of those investors interested in funds of hedge funds, the family office set proved the most keen -a reflection of the sobering post-crisis reality that trying to build a portfolio of managers and strategies on your own is not only difficult and costly but also potentially hazardous.

Source: Brighton House Associates

Real estate funds also benefited from a fourth-quarter market rebound, especially in the US and Europe where investors were interested in sourcing fund opportunities in commercial real estate, according to the survey. Interest in CTA / managed futures funds of funds also gained traction, thanks in large part to rising prices for gold and other commodities. Investors even expressed interest in private equity funds, particularly those focused on buyout opportunities.

Source: Brighton House Associates

And in all the talk about increased investor interest, rising inflows and diversification into various alternatives strategies, the bad news?

There isn’t any, according to the report.

“Early indications for 2010 are that the loosening of credit is finally beginning to have a significant impact on the alternative investment community as capital is beginning to flow back into the industry following the redemptions sparked by the crisis in 2008.”

Let’s all hope so.

It’s among the most common of mistakes an investor can make: holding on to a stock or security because it’s a great company, because it produces great products or services or because eventually, one day, it’ll go back up in value.

Hedge fund managers are apparently no different. According to Hedgebay Trading, prices paid for hedge fund assets on the secondary market fell to an all-time low in December, with sellers getting less than 80 cents on the dollar. More…

Two thousand and eight was all about the big drop in hedge fund returns, while 2009 was all about the big rebound.

So with the markets seemingly having righted themselves, the focus among investors this year is coming back to strategy - convertible arbitrage, distressed, global macro, technology and others that fall under various categories depending upon what their managers do and on what markets they are focused.

One strategy commanding particular attention is merger arbitrage, which still managed to produce so-so returns last year (see chart below). More…

By: Dr. Bob Swarup, AllAboutAlpha.com Editorial Board.

Over the last year, the hedge fund industry has witnessed a development of truly Olympic proportions.  After a multi-year run-up, gold has finally become the belle du jour of the hedge fund community.  For example, John Paulson recently announced he was launching a gold fund and plugging $250mn of his own money into it; Paul Tudor Jones revealed that he had become the latest recruit to the gold bug movement; and Stanley Fink’s new shop is planning to join the party with a gold fund – the latest in a series of funds focused on the sector. More…

The hedge fund industry’s insatiable thirst for market research will be temporarily quenched this week by an interesting new report from SEI and Greenwich Associates.  The document, called “The Era of the Investor” contains results from the firms’ second annual survey of institutional investors (conducted in November 2009) and is sure to generate a lot of press in the next few days.

Since this thing is destined to be well covered by the mainstream media, we thought we’d try to look a little deeper into the results and focus on some findings that aren’t immediately obvious or covered in the executive summary.

But first, the headlines… More…