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Did The Subprime Focused Hedge Funds Take Advantage of the Crisis?

A working paper by Christos I. Giannikos and Panagiotis Schizas try to answer whether subprime focused hedge funds knew what was coming and took advantage of the crisis. Here is an excerpt from their working paper:

This work contributes to the studies of the performance of hedge funds during crises. But it specializes in those hedge funds that focus in subprime mortgage strategies and the common risk factors affecting them. Brummermeier and Nagel (2004), who studied hedge funds during the technology bubble, argued that they did not avoid the particular downturn of the market. During the period of the study the market peaked in September 1999, while the hedge funds valuation did so 6 months later6. Since the most sophisticated investors, i.e. the hedge funds, failed to identify the technology bubble then, it is interesting to explore whether they used their recent experience to benefit from the recent crisis. Therefore this study is also a further evaluation of the perceived sophistication of hedge funds. It plainly asks first the question: did the subprime focused hedge funds take advantage of the recent crisis?

This paper documents that hedge funds specializing in Sub-prime mortgages did not take advantage of the housing bubble and they did not trade against it. Hedge fund capitalization is an important factor regarding how funds suffered during the crisis. Small funds suffered the most. Mid and small cap portfolios took into account housing prices while fund managers of large portfolios used mainly subprime loan foreclosures. Also, mid cap portfolio primarily relied on macroeconomic indicators (mortgage ARM rates, housing prices, subprime foreclosures) and, as a result, suffered less compared to their peers above. Duration and quality of the credit instruments are significant factors in explaining hedge funds returns. Naturally, our study, in line with the existing literature during turbulent periods, documents that the lack of liquidity was a key driver of performance.

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