At the start of the coronavirus pandemic in early 2020, the world faced a health crisis on a scale unmatched since the flu pandemic of 1918. Many countries mandated lockdowns and other significant social distancing measures, which led to a sharp fall in economic activity and liquidity in the financial markets.
In a recent report,1 Blackrock referred to the 2008 financial crisis as a credit crisis, and Covid as a liquidity one.
What were the key liquidity risk factors which arose at the start of the pandemic?
This above report made some crucial observations, which have been summarised below:
- Accessing liquidity for fixed-income equities became more expensive
- Bond funds remained diverse – and some high-quality funds even attracted inflows during March 2020
- As would be expected with market volatility, portfolio rebalancing, de-risking and corporate bonds sales were a common theme
How have hedge funds performed during the pandemic?
Data collected in the ‘2021 Global Hedge Fund Survey’2 showed the 50 best-performing hedge funds grew just over 24% in 2020. This exceeded the S&P Index, which grew 18.40% over the same period – which was still an impressive recovery considering the relative turmoil earlier that year.
What did the pandemic expose about liquidity risk management in the banking sector?
A report from the international Financial Stability Board3, which was set up after the G20 Summit in London in 2009, revealed that liquidity mismatches, leverage and interconnectedness were possible causes of liquidity imbalances. We also saw a 'dash-for-cash' in March 2020, which led to global ‘risk-off’ sentiments, causing investors to get rid of riskier assets for cash, which is seen as a safe haven for investors.
The report's1 authors called for a more resilient non-banking financial intermediation (NBFI) sector and highlighted three key questions for the future:
- Have post-2008 crisis reforms improved financial resilience?
- Did the global regulatory framework provide the necessary flexibility to deal with the pandemic shock?
- Is the global financial system too pro-cyclical? For example, with regards to margin calls and the actions of private investors, as well as the use of external credit ratings
What does this have to do with hedge fund liquidity risk management?
The liquidity mismatches referred to in this report – like whether or not investors can buy or liquidate their investments as timeously as they were led to believe – have been identified as a key risk factor for the alternative investments market.
These findings from the Financial Stability Board report are in accordance with the European Securities and Markets Authority (ESMA).4 Its fourth annual statistical report in February 2022 highlighted the mismatch between the potential liquidity of assets and redemption timeframe as being the main risk for hedge funds.
Essentially, these funds would face challenges if a significant portion of their investors decided to make large withdrawals all at once or in a very short period.
Here are some key statistics from this report
The European Economic Area Alternative Investment Fund (EEA AIF) market expanded to a net asset value (NAV) of €5.9 trillion by the end of 2020 – 8% higher than 2019. Investors can redeem 40% of the NAV in one day. Realistically though, only 14% of assets could actually be liquidated in this time frame. This is a significant liquidity risk for hedge funds.
Real estate funds are also exposed to illiquid physical assets, as these can take time to sell, so there is considerable liquidity risk in this space.
How did Brexit affect the hedge fund landscape across the EEA?
Similar to the coronavirus, Brexit caused a great deal of instability and uncertainty to the industry. And like the pandemic, the chief concern revolved around the risk imposed by liquidity on hedge funds:
- The size of the EEA's hedge fund sector fell substantially after Brexit – from €359 billion in 2019 to €89 billion in 2020 – but leverage remains very high
- In 2019, the UK accounted for three quarters of all hedge fund NAVs, which explains this large fall
- The remaining hedge funds in the EU are largely concentrated in Ireland and Luxembourg
Why is this liquidity mismatch such a big concern from a risk-management perspective?
Hedge funds’ assets can be liquidated quickly to meet investors’ redemption demands.
It’s the timeframe in which those redemptions occur and whether hedge funds can raise enough funds to meet their obligations that exposes managers to high liquidity risk (at least, in theory).
Some hedge funds have been known to finance more than half of their funding overnight to meet those demands. In fact, the ESMA report4 found that more than 90% of equity hedge funds engage purely in overnight borrowing, which exposes them to much higher rollover (refinancing) risk.
But hedge funds are, by definition, high-risk investments, so the question is: how can managers strike the right balance between meeting their redemption obligations and protecting the integrity of their funds.
Which were the most successful hedge fund strategies during the pandemic?
According to data collected by Backstop BarclayHedge in 2020:
The S&P 500 total return was the most successful hedge fund strategy, delivering net returns of 18.4%. Next in line was equity long bias at 16.31%, followed by volatility trading, at 15.87%, 15 equity long-short funds in the 50 top-performing hedge funds accounted for almost a fifth (19.5%) per year for the five years up until the end of 2020
The strategy average return for the same period was only 4.5%.
As with all investments, assessing any fund's performance based on only one year of data can paint a different picture to the fund’s long-term performance (ie ten or 20 years). However, despite the pandemic-related turmoil, hedge funds had an 'extraordinary breadth of performance by strategy' in 2020, when commenting on the data he published at Ria Intel. This online publication, targeted at institutional investors, provides insights and commentary into some of the world's fastest-growing Registered Investment Advisers (RIAs).
Why is the above relevant to liquidity risk?
During any period of economic turbulence – such as the spring of 2020 – prices can be subject to large swings, and hedge fund managers may face a large number of redemption requests in a short space of time. This exposes them to much higher liquidity risk, so it’s interesting that hedge funds performed strongly during an extremely volatile year.
Smaller funds may have a strategic advantage
Interestingly, managers of small hedge funds can 'invest meaningfully across a wider universe', says Eric Costa, global head of the hedge funds investment group at Cambridge Associates consultancy. They can 'move in and out of positions more nimbly' compared to their larger peers without affecting prices.
their performance even further, for example, through competitive margining, smart order
Whatever the size of a hedge fund, managers that partner with a prime broker can optimise routing (SOR), algorithmic trading technology and access to multiple global exchanges.
Our research has revealed some interesting trends in the hedge fund space. Firstly, Brexit has significantly reduced the EEA's share of the hedge fund sector, even though the AIF market there grew overall from 2019 to 2020 (the UK left the EU on January 31st, 2020). Secondly, portfolio rebalancing, volatility and de-risking were commonplace during the pandemic. Thirdly, hedge funds face significant liquidity risks when a high volume of redemption requests are made at short notice.
As the pandemic comes to an end and Covid-19 transitions into an endemic state, IG Prime will continue to explore the future of liquidity risk management in the hedge fund sector with analysis and insights for investors.
- Lessons from COVID-19: Liquidity Risk Management is Central to Open-Ended Funds Report, 2020
- Global Hedge Fund Survey, 2021Financial Stability Board, 2021
- EU Alternative Investment Funds, ESMA Annual Statistical Report, 2022
- RIA Intel - Proven Hedge Funds Excelled During the Pandemic