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Is it common to see hedge funds go bankrupt?

Economics Asked on April 5, 2021

Have any hedge funds gone bankrupt as a consequence of the "GameStop scandal"?

And more generally is it common to see hedge funds go bankrupt?

One Answer

Have any hedge funds gone bankrupt as a consequence of the "GameStop scandal"?

This is very difficult, almost virtually impossible to say as events unfold. In order to understand why consider the Greylock Capital Associates that filed for bankruptcy on 31 Jan. this year.

It would be tempting to say that this bankruptcy occurred due to GME stock shorting, but if you actually read the news around the bankruptcy you will discover that the company was already suffering heavy losses for about 3 years.

This example shows you that hedge funds and generally most companies can operate even when in red for multiple years before they need to file for bankruptcy. As such, most of the time, it is really difficult to tie one single event to firm bankruptcy. Generally speaking, from economic theory we know that in the short-run even operating at loss might be more optimal than firm exit.

Even if some hedge fund representative would openly say that they went bankrupt because of GME shorts during this GME bubble fueled by reddit speculators, you can't take that statement at face value. The manager might simply say that as an excuse for years of poor management and underperformance.

What you need to answer this sort of question is some research that can show that there is a relationship between shorting the GME bubble and probability of bankruptcy, which would show that probability of hedge fund going bankrupt was significantly affected by this event. Otherwise all you have are just anecdotes.

Since this case was so prominent I expect that eventually someone will try research it but I doubt you will find any empirical peer-reviewed research on this in next 2-3 years even more. This is not just because research takes time but also because you need to gather more data than possibly can be avaiable in real time.

And more generally is it common to see hedge funds make bankrupt.

Depends on how broadly you define bankrupt (e.g. are you only interested in bankruptcy in legal sense or more broadly in English language sense when people often call any firm closing bankruptcy?). For example, according to Liang & Park (2010) between 1995-2004 hedge funds had attrition rate of about 8% on yearly basis. Although, not all of that is bankruptcy as some firms might leave before filing for bankruptcy. There is reason to believe this rate accelerated over time. For example, in 2019 more hedge funds closed than new opened.

Hedge funds have relatively high rate of attrition because:

  1. They have very few limits on how to operate so hedge funds industry is very dynamic. In a dynamic industry you will often see old firms 'dying' while new innovative firms coming in (e.g. see the NBER working paper of Getmansky et al (2015) on this topic). This is explanation why hedge funds close quite often in general but probably cannot explain why they close so fast in recent few years.
  2. It is widely believed that hedge funds perform poorly relative to their high fees. This is often quoted reason for why many hedge funds loose customers and are forced to close or go bankrupt recently. See the Investopedia article on 'the great exodus out of hedge funds'. This is topic on which research is not settled. On one hand raw data clearly show hedge funds underperform. On the other hand this might be due to biases since hedge funds are not obliged to disclose their data to anyone but their customers and regulators. This can create biases in the data as the best firms might not disclose publicly their data to protect their trading strategies that are not patentable (e.g. see Fung et al (2000) or above cited Getmansky et al (2015) again). Depending on how particular research tries to correct for these biases results can change and some are more favorable to hedge funds but there is a lot of uncertainty about the results here. This being said customers would not be leaving the hedge funds if they were not believing that they are having better opportunities elsewhere.

Correct answer by 1muflon1 on April 5, 2021

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