(December 3, 2012) — How has the financial crisis impacted hedge funds and the existence of fire sales, which occurs when these investors experience outflows and sell stocks that are common across their portfolios?
One newly released academic paper by Nicole Boyson of Northeastern University, Jean Helwege of University of South Carolina, and Jan Jindra of Ohio State University investigates hedge fund stock trading from 1998 and 2010 to test for fire sales.
The paper argues against a commonly held view of hedge funds in the subprime crisis, which describes them as victims of severe outflows and margin calls that forced them to sell assets into a declining market. “While many of the stylized facts suggest that the financial crisis was exacerbated by forced sales of stocks by hedge funds, our analysis suggests otherwise,” the report concludes.
The paper continues: “While funds with high capital outflows sell large amounts of stock during crises, these funds also buy stock, rather than using all the proceeds to fulfill redemptions. Further, funds with large outflows rarely sell the same stocks at the same time,” the paper explains. “For the relatively few stocks that are sold en masse, there is no evidence of price pressure, largely because hedge funds overwhelmingly choose to sell their most liquid, largest, and best-performing stocks. We provide new and compelling evidence that hedge funds neither engage in nor induce fire sales, since their well-diversified portfolios allow them to cherry-pick the most appropriate stocks to sell during crises.”
The authors explain their analysis of whether hedge fund stock sales in crisis can be characterized as fire sales. “We use two fund-specific proxies for liquidity shocks: fund flows and fund-imposed capital lockup and redemption periods. Controlling for a variety of fund characteristics, we find that during crises funds with high outflows sell significantly more stock than funds with high inflows, consistent with liquidity shocks imposing selling pressure. However, on average, funds with outflows use nearly all their proceeds from stock sales to buy additional stock, inconsistent with forced sales.”
For hedge funds to be a source of stress in a crisis, the authors explain, not only must they sell large quantities of assets to meet margin calls and redemptions, but also the asset sales must put downward pressure on prices. The paper asserts that while hedge funds experiencing outflows sell more stock than funds experiencing inflows, and outflows are larger during crises, there is no evidence that these stock sales occur at fire sale prices.
“We also show that hedge funds hold well-diversified portfolios and rarely sell the same stocks at the same time. This evidence calls into question the extent to which hedge funds are forced to sell into a falling market,” the paper explains.