Why hedge funds performed better in 2008 crisis and will banks learn the lessons?

As the 2008 crisis unfolded most thought hedge funds would lead to further chaos with their highly leveraged and risky structures. But this was not to be barring a few cases here and there. Why so?

Dallas Fed note tells the story. The hedge funds post LTCM crisis have made efforts to diversify and not follow the herd mentality:

Hedge funds provide an example of intermediary diversity and crisis experience. A prominent historical example of correlated losses occurred when numerous hedge funds needed to close out similar portfolio positions simultaneously as Long-Term Capital Management (LTCM) collapsed in 1998 under the weight of its highly leveraged, derivative-laden holdings.

After that experience, financial authorities became especially wary of the potential for correlated risks in the hedge fund industry, making it a particularly interesting intermediary class for a diversity assessment. For data, we examined compound monthly returns by year for 1,190 dollar-based hedge funds that reported continuously in the Lipper TASS database from 2004 through June 2011.[5]

They analyse hedge funds over the years:

The first pattern of note involves the distribution of returns during the boom of 2004–06. Little change occurred over this period, other than a slight upward trend. But more importantly, even under these highly favorable operating conditions, a substantial level of diversity in returns is apparent, with the return percentiles during the boom period covering a fairly broad range, from around zero to more than 2 percent.[6]

In 2007, the return distribution widened further as the crisis began. Severe losses ensued for many funds in 2008 in the midst of the crisis. But interestingly, in this down year, the 95th percentile held fairly firm, with some funds managing to earn high profits even in the toughest of environments.

Coming out of the crisis, 2009 was a banner year for many funds, presumably reflecting strategic positioning ahead of a market bounceback. But then in 2010, returns declined to more normal levels and kept falling during the first half of 2011, with the current year turning out to be a rough one for the industry. The return distribution has remained a little wider following the crisis than prior to it.

Overall, return disparities across hedge funds suggest considerable diversity in risk exposures and outcomes. Of particular interest is how the risk differences observed across hedge funds played out during the boom years and subsequent crisis; that is, were the same funds always among the top performers, year after year, or did the relative rankings of individual funds change significantly?

To the q at the end, they find conservative funds which dont do as well in boom times generate better returns in the crisis.

Hmmm..

The LTCM crisis shook the hedge fund world and seem to have reformed since then. Will Banks and I-banks (whichever are left) learn similar lessons? The current evidence does not really point in the desired direction…

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