What impact do hedge funds have on market liquidity?

In this article, we will explore this dual nature of hedge funds, i.e., how they both facilitate and can potentially threaten market liquidity.

One of the first hedge funds was founded in 1949 by Alfred Winslow Jones. Since the fund applied the practice of hedging risks by balancing long positions with short-selling, such funds came to be known as hedge funds.

Over time, the influence of hedge funds in financial markets has burgeoned. As hedge funds often take opposing positions with borrowed funds, they often act as market makers. Thus, they play an important role in price discovery, reducing volatility, and preventing forced sell-offs. However, since hedge funds operate with a high amount of leverage, the liquidity they facilitate is often dependent on borrowing costs.

What are hedge funds?

Hedge funds pool money from investors and institutional investors to apply various strategies across stocks, private equity, bonds, real estate, commodities, currencies, and derivatives. These funds often apply high-risk strategies such as merger and acquisition (M&A) arbitrage, and highly leveraged derivative strategies to capture returns higher than traditional investments.

For instance, the Nasdaq Composite grew at a CAGR of 11.94% between 1988 and 2021, while Medallion Fund, a renowned hedge fund, grew at a CAGR of 62% in the same period.

Another characteristic of hedge funds is the high management fees. In the case of Medallion Fund, despite the fund growing at a CAGR of 62%, the investors realized only 37% returns on an annualized basis.

Since hedge funds often invest in alternative assets that lack active markets, their investors are required to stay invested for the long term in the fund. If a hedge fund has a long-term focus or invests specifically in assets such as startup equity, the holding period can be multiple years.

Hedge funds as market makers

Certain hedge fund activities that can result in improved liquidity for various assets are as follows.

Investing in illiquid assets

In search of extraordinary returns, hedge funds will often invest in illiquid assets such as low market cap public companies, startups, real estate, and even art and collectibles. Such assets typically do not have active markets. Hence, the demand created by hedge funds can significantly reduce investment periods for many players and create valuable exit opportunities.

From the perspective of hedge funds, these assets are attractive since they carry an illiquidity risk premium. Furthermore, due to low trading activity, these assets can often be bought for discounts to their intrinsic values.

Derivatives

Derivatives such as futures, options, forwards, and swaps can be used to mitigate risks from certain existing positions in related assets. At the same time, they can also be used to gain more exposure to a speculative position. Given their high-risk investing style, hedge funds are likely to use derivatives for both these purposes. By creating a demand for derivatives, hedge funds ultimately contribute to market liquidity.

Firstly, by creating risk mitigation opportunities, derivatives encourage greater participation. Secondly, derivatives contribute to price discovery by throwing light on arbitrage opportunities created due to inaccuracies in asset prices and derivative prices.

Thirdly, the trading volumes generated by derivatives, directly and indirectly, can provide much-needed exit opportunities.

Leveraged investing

Hedge funds often follow the practice of investing and entering positions with borrowed funds. So, the market liquidity impact of hedge funds can be much larger than the capital managed by them. As of 31st December 2024, hedge funds employing macro, multi-strategy, and relative value strategies operated with net asset-weighted average leverage ratios of 6.8x, 4.4x, and 6.3x, respectively.

When measured by gross leverage, funds following relative value strategies reached a leverage level of 19.3x by the end of 2024.

Role of hedge funds in liquidity spirals

Much of the liquidity created by hedge funds is through borrowed funds. So, when borrowing costs increase, the liquidity introduced by hedge funds gets withdrawn. Since most forms of asset purchasing activity slow down when borrowing costs increase, the withdrawal of liquidity created by hedge funds may cause liquidity spirals.

Role of hedge funds in liquidity spirals

Source: financialresearch.gov

The above graph plots the leverage ratio of the top 10 hedge funds and the interest rate targeted by the Federal Reserve. The interest rate is plotted in percentage terms on the right axis, while the leverage ratio is plotted in multiples on the left axis.

During the zero-interest-rate period, hedge fund leverage peaked near 25x, reflecting the low cost of borrowing. However, as the Fed began raising rates, leverage steadily declined, reaching a low below 15x. This inverse relationship supports the theory that higher borrowing costs reduce the appetite for leverage among hedge funds.

When hedge funds drastically reduce their leverage, it leads to a sudden drop in market liquidity. This phenomenon can have far-reaching and devastating consequences that can destabilize financial markets and hinder economic activity, some of which are as follows:

The Impact of Hedge Fund Deleveraging on Market Liquidity and Economic Stability

These effects can destabilize financial markets and hinder economic activity, as observed in historical crises and supported by empirical research.

  • Breakdown of price discovery mechanisms – As the trading volume of an asset declines, we experience a drop in price discovery. This would increase volatility and valuation multiples also become unreliable. Investors also lose confidence in the fairness and accuracy of asset pricing and discourage market participation.
  • Sell-offs and distressed exits – A lack of market liquidity makes investors anxious about securing exits. As trades become infrequent, asset holders must always stay on the lookout for purchasing intent in the market. Since there is a possibility that the next exit opportunity will not arrive for an extended period, asset holders are compelled to sell at low prices. This creates a negative feedback where low liquidity forces asset sales at low prices, which in turn reinforces lower valuations and erodes market confidence.
  • Extreme aversion to risk – Typically, market liquidity will subside from riskier assets first as investors rush towards safer assets. This phenomenon disproportionately affects early-stage startups and small enterprises, which slows down capital formation in sectors that are critical for innovation and economic growth. If this trend continues,it leads to a significant slowdown in economic activity.

Hoarding tendencies of hedge funds

Hedge funds can create an artificial scarcity to drive up asset prices by accumulating and restricting the supply of assets. This strategy is effective when the underlying demand for the asset is stable or inelastic. In some cases, hedge funds may further improve returns by lending out these hoarded assets, generating an additional stream of income. This strategy allows hedge funds to extract capital gains as well as rental or lending income from the same asset.

An area where this practice has been discovered and heavily criticized is the residential real estate market.

According to Redfin data, 16.5% of all single-family home purchases in Q4 2024 were made by investors. In fact, for the last two decades, investor activity has concentrated in the single-family residential real estate space, as shown by the following graph.

property type

Source: Redfin

Not only does this practice dry up market liquidity, but it also leaves the market vulnerable to fraudulent manipulative practices. When trading volumes are low, the potential of small trades skewing market prices is high. So, in order to further drive up asset prices, fraudulent parties may overbid on new assets to inflate the value of similar assets in their portfolio.

Hence, it is no surprise that states such as Texas, New York, and Virginia are exploring legislation to ban investment firms such as hedge funds from buying residential properties. Lawmakers across the nation have lamented how this practice makes it challenging for average Americans to purchase homes.

Eqvista – Valuation insights you can bank on!

Financial markets consist of various players whose behavior can be difficult to gauge. Hedge funds are one example. Understanding their impact on market liquidity takes nuance. You must understand their operating principles and investing goals to catch their role.

Similarly, sovereign wealth funds are another player whose impact on markets is complex and often opaque. Due to their massive size, the smallest portfolio adjustments by these funds can move markets. However, they often operate through intermediaries and hence their influence is often invisible. At the same time, since these funds may operate with undisclosed political or strategic objectives, their behavior can be difficult to predict.

In such a dynamic and complex investing landscape, expert insight is essential. As a trusted valuation service provider, Eqvista helps clients navigate this complexity with confidence. Every month, we value about $3 billion in client assets to empower investment decision-making and enable tax-compliant issuance of stock-based compensation. Contact us to know more!

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