Hedge Fund Tumble?

In the current stock market sell-off, a new phase appears to have been reached. Market participants have apparently given up hoping that stocks will come back up any time soon. The rather dramatic downtrend will apparently continue, and now the game is all about finding a reasonable explanation why it is so.

This being said, I tend to agree that there is a lot of companies out there trading at prices that are compatible with a deep and long recession. If this economic downturn does not materialise or if its severity falls short of what market participants currently think, the streets are littered with bargains, and some even represent that wet dream of value investors, companies selling at a market value below their cash holdings.

Unfortunately, this does not preclude a further price fall, and I am afraid I lean towards believing that they there is indeed further downwards potential, and this is for reasons linked to hedge funds.

We all know that the word “hedge” in hedge funds is but a historical remnant from a long gone period where such funds would in fact hedge parts of their portfolio. Later such funds got the more appropriate mention “long-short funds”. Among all the various categories of hedge funds, the long-short funds have always been the dominant, dwarfing all other categories. Originally this category of funds did in fact hedge some or most market risk, relying on long stock picks to provide the return.

As the number of hedge funds grew rapidly, not least because of the handsome remuneration and the near-complete obscurity about their actual positions, their returns began to look more and more like that of simple index investment, leveraged a couple of times. That was not very surprising, simply reflecting the law of large numbers.

And something else: stories began to abound that a large number of long-short funds were actually more leveraged directional bets than anything else. Apparently many funds gave up pretending to do the long-short thing, with markets powering ahead it was more attractive just to run with the market – leveraged.

It is also well known that hedge funds on top of being unregulated and deploying remuneration schemes out of line with performance, have used a quite insidious lock-up method. Their positions have apparently been so complex and difficult to liquidate that investors had to accept only to have quarterly liquidity, and often with at least a month long notice period.

Now fast-forward to the current situation. At the beginning of the year, hedge fund assets likely stood in excess of $2.75tn, and it appears safe to assume with the lion’s share in equities or equity-linked products. The goings-on around Bear, Sterns led to some withdrawals, but the brunt of the financial crisis set in just after 1 September, leaving a lot of investors with having to wait until December before they can announce the withdrawals for year end. These withdrawals are likely to be massive, given the collapsing risk appetite in the markets. Rumours and talk in the market points to the possibility of a 10-25% withdrawal. Even if the average hedge fund has lost more than 20% in value since the beginning of the year, even if not all of the hedge fund assets are invested in equity related products and even if some withdrawals have already taken place, the amounts are likely to be significant.

On the other hand, there are the banks who have extended credits to the hedge funds, often in highly incestuous “prime broker” arrangements. The banks are now under a heavy pressure to reduce risks, and obvious the hedge funds are in their sights, meeting margin calls from the lenders.

So it is obvious that we are looking at a huge squeeze here, and if my timeline is correct, we have only seen the beginning. Discerning hedge fund managers (an oxymoron?) have of course begun to unwind positions some time ago. But I have trouble believing that there is not much more to come as we come closer to crunch time around the turn of the year.

There may some who believe that some of the Bailout Money from the US government could be used to help hedge funds in distress. No such luck, as US Treasury Secretary Paulson has been adamant that those funds will go exclusively to "federally regulated financial institutions that lend money".

Already now, pundits believe it likely that up to a 1000 hedge funds may fold over the coming months, some in an orderly fashion, some will come crashing down. Some of them will have been invested in products related to credit derivatives and so on. In no circumstances it will look nice.

In order to end on a different note, try to think over what will happen to the pension funds if massive withdrawals from the hedge funds leads to a continued negative stock market. Let us assume that the market can fall another 30 per cent on hedge fund liquidations alone. The question is then: how many defined benefits pension schemes around the world will have to hit the panic button and reduce stock market exposure in order to avoid being unable to mathematically meet future liabilities?

Anybody for more bad news? I hope somebody out there will correct my line of argument here. Otherwise, stock markets will risk going from very bad to rather worse, I am afraid.