LONDON (HedgeWorld.com)–The liquidation of Long-Term Capital Management after the Russian government defaulted on its rouble-denominated debt is a chilling reminder for any hedge fund investor of what can happen when a bold strategy goes catastrophically wrong.
It is thus unsurprising that a whole body of literature is emerging to analyse hedge fund survival and attrition rates. The process gained further impetus from a March Bank of Japan study which used Lipper Tass data to show that the recent rapid creation of funds has led to only a modest increase in liquidations.
Another recent salvo is ‘Competing Risks in Hedge Fund Survival’ by Fabrice Rouah, a PhD candidate in Management at McGill University in Montreal. He aims to go beyond the BoJ study by isolating liquidation from other exits.
Doing so leads him to conclude that yearly attrition rates are around one-half those obtained when all exits are used to define dead funds. He also found that hedge fund lifetimes depend on a number of predictor variables and, by isolating liquidation, expected lifetimes are about twice as long as those estimated when exits are aggregated.
Mr Rouah’s paper, the BoJ study and other research is of growing importance in the hedge fund industry. One reason for this is the increasing attention hedge funds are getting from institutional investors. The corollary, of course, is that the amount of money on the table is expanding rapidly.
Clearly, institutions will seek to avoid capital losses and the worst case scenario that liquidation implies. Thus, portfolio insurance and capital guarantees are gaining in popularity, Mr Rouah notes.
The need to split apart liquidation from other exits seems obvious enough. “”Survival analysis can serve as a tool for due diligence of hedge funds, since it can help investors identify fund characteristics that are associated with longevity and help them select hedge funds less likely to liquidate,” he says.