What are the causes of a declining performance of Hedge Funds since the Subprime Crisis?

Abstract

Hedge funds, often enveloped in mystery and intrigue, have remained a captivating subject for academics. Our thesis aimed to delve deeper into this subject with a primary focus on understanding their performance trends and the assessing a decline in returns post the financial crisis of 2008. At the heart of our research were two pivotal questions: Has the hedge fund’s performance truly declined after the global financial crisis of 2008? and What are the causes of such a decline in performance? Our methodological approach for this inquiry centered around analyzing returns of 4,557 hedge funds from 1998 to 2021. These funds, segmented into nine unique strategies, provided a comprehensive view of hedge funds industry’s performance across various periods: pre-financial crisis, during the 2008 crisis, post-crisis, and the Covid-19 pandemic. The results were quite revealing. Before 2008, hedge funds, especially those under "Long Short Equities" and "Relative Value" categories, exhibited superior alphas. During the tumultuous period of the 2008 crisis, some strategies like “CTA/Managed Futures” and “Macro” demonstrated impressive resilience. However, the post-crisis era marked a pronounced decline in alpha but still postive across all strategies. A trend which intensified during the Covid-19 pandemic. Our regression using CAPM, Fung &Hsieh 7 factors model and JKKT model analyses further highlighted a consistent drop in alpha generation, a key performance indicator, post the 2008 crisis. Digging deeper into the causes, several insights emerged. Central bank interventions post-2008 seemed to amplify correlations between certain investment strategies and the broader market. This heightened correlation, especially evident in strategies such as stock-picking and "Long-Short," potentially made them less effective. Additionally, the market witnessed a surge in the number of hedge funds post-crisis, leading to intensified competition and possibly diluting returns due to overlapping investment opportunities. Furthermore, an accelerated growth in the number of hedge funds, especially post-crisis, has surged competition for lucrative investments, thereby potentially thinning profit margins Beyond market dynamics, hedge funds themselves underwent strategic shifts. They began showing reduced sensitivity to interest rates and credit spreads, signaling a potential strategic shift in bond investments. Moreover, a significant post-crisis negative exposure to the momentum factor was observed across multiple strategies. This could be attributed either to deliberate contrarian approaches or inadvertent poor stock choices. Notably, many hedge funds also showed a growing inclination towards the BAB factor, emphasizing stability in uncertain times but potentially missing out on high-reward market rebounds. In conclusion, our study underscores a clear decline in hedge fund performance following the 2008 financial crisis. While several factors, including central bank interventions, increased competition, and strategic shifts, contribute to this trend, it's pivotal to note that this decline might just be a phase in the ever-evolving world of hedge funds. Observing their trajectory in the coming years will be instrumental in discerning future sector dynamics.