Things You Need To Know Regarding Hedge Fund Liquidations

During the stock market decline (or "crash") of October 2008, various media outlets have loudly identified the impact of massive hedge fund liquidations as a key ingredient to the huge equity sell-off.

However, as an "average" individual investor, how well do you really understand how or why these mysterious investment funds have acted in such a brazen manner?

Let's explore five things that you need to understand about hedge fund liquidations.

1. Meeting Redemptions

A hedge fund does not have to continually invest, as a mutual fund does. Rather, a hedge fund will allow its investors (typically "limited partners") to redeem all or part of their investments on a periodic basis. These redemptions usually follow very strict guidelines in accordance with the hedge fund operating agreement.

Typically, limited partners can only withdraw funds on a quarterly or annual basis. Furthermore, advanced notice (30 or more days) for redemption to the hedge fund manager is often required. Just as there may be a "run on a bank" there can also be a run on a hedge fund -- especially when performance is poor. Thus when redemptions occur they tend to be clustered across the entire hedge fund industry in a small window of time.

2. The FOF Effect

There are certain hedge funds which are set up as portfolios of other hedge funds. These are referred to as fund of funds (FOF). The concept is to diversify amongst many hedge funds. However, when a FOF is in redemption mode it has a decision to make: Either the FOF redeems an equal amount of investments across all of its hedge funds or it pulls out larger amounts from a few hedge funds.

Selling a small amount of many funds may have little impact on the liquidity of a single fund. However, liquidating a large portion from one fund could have dire consequences upon that individual fund.

3. Leverage

Average investors are subject to Federal Reserve Regulation T. Under Regulation T an investor can purchase a stock by borrowing money from a broker-dealer in a margin account. Under the margin rules the investor has to put up 50% of the purchase price in cash or other margin collateral. The other 50% is borrowed from the broker-dealer. Thus under Regulation T the investor has 2-to-1 leverage. Theoretically, the investment has to depreciate by 50% in order for the investor to be wiped out of their equity.

On the other hand, many hedge funds are levered through offshore facilities and in derivative contracts, whereby they can obtain leverage far greater 2-to-1. So what? Smaller losses have far greater impact on the equity of the fund.

Let's say a hedge fund's leverage is 5-to-1 and it's redemption time. In order to meet those redemptions, the hedge fund will have to sell at least $5 of investments for every $1 of required redemptions.

As redemptions tend to be clustered, the impact on individual stocks from hedge funds liquidating their holdings (to meet those redemptions) will be a magnified and concentrated hit on those stocks, and potentially the overall market.

Since the hedge funds are more concerned about creating liquidity than preserving the integrity of their portfolios during a crisis, the higher priced stocks tend to get sold first. It is far easier to create $10,000,000 of cash by selling smaller amounts of a $200 stock, say aapl, than larger amounts of a $25 stock, say mo. And before you know it, that $200 stock has become a $100 stock. "Classic" valuation is thrown out the window.

4. The Futures Effect

Liquidating large amounts of stock for an individual fund can be a complex task:
# Many of these hedge funds have outsized positions.

# When another hedge fund sees a commonly held position begin to sell off there is a tendency to also enter the fray, causing a run on the stock.

# Sometimes, there are hedges on the other side of the liquidation. Both sides have to be unwound simultaneously. In a fast or disjointed market this can cause confusion and risk management issues.

And when many hedge funds liquidate simultaneously, we have a rush to exit the markets as if there were a fire in a movie theater.

In order to "front-run" the need to liquidate, some hedge funds will sell index futures in order to hedge or anticipate the required liquidation.

Futures -- especially if sold before the market opens -- can set the markets up for a nasty fall. This has the effect of yelling fire in a crowded movie theater and in investment terms, panic selling may ensue. Once futures are sold off in this dramatic fashion, traditional indexed funds are forced to sell stocks in order to adjust their holdings to the perceived discount to fair value. A self perpetuating sell-off develops and markets rapidly head lower.

5. Extreme Herd Mentality

Hedge funds tend to act as a herd. While this may be no different than how individual investors think and behave, within the hedge fund community, because of these funds' massive sizes and access to lightening fast execution programs this herd phenomena develops in a more concentrated, more leveraged and rapid manner.

While hedge funds are natural competitors with one another, they also share information amongst their brethren. Furthermore, the sell side brokers will tend to market the same trade to many of their hedge fund clients, once they spot what trades are taking place. I have seen this happen time and time again.

For example, if ABC, a successful hedge fund, is buying commodity stocks and shorting retail stocks, then a diligent salesperson will ring up hedge fund XYZ to tell them what the "smart money" is doing. This then has a multiplicative effect and before you know it the entire hedge fund industry is loaded up on the same trade.

As long as the trade works, this is great for the saleperson and for the hedge funds. However, once the hedge funds unwind these concentrated and leveraged trades -- whether having to redeem or deleverage or manage risk -- there is a massive rush to the exits. We call these "Katy Bar the Door" moments (a commonly used Wall Street phrase for when everyone is trying to exit at the same time).

A great example of the herd trend in action is the "carry trade."

In the carry trade hedge funds will borrow money in a low interest currency and buy assets in a higher interest currency. For example, selling Japanese Yen (JPY) at 0.5% and reinvesting in U.S. Dollars at 3%. This trade works well as long as the exchange rate between the two currencies is stable. However, once the trade stops working (or as we say in the industry is no longer "setting up") or there is a coordinated exit from the trade, this will result in huge dislocations in the pricing of these assets without regard to the true fundamentals.

Recall the huge rally in JPY last week, as the carry trade was unwound by liquidating hedge funds. Then noticed what happened to JPY this week, once the unwinding ceased.

Your Homework

# Spot market dislocations related to hedge fund liquidations, as valuations become increasingly cheap and selling seems to become irrational.

A great example of this type of dislocation was FCX's activity, which was recently subject to hedge funds liquidating en masse.

# Identify when futures markets are moving by wide margins, without any associated economic or fundamental news. Instead of panicking and be shaken out of the market, use these situations in an opportunistic way.