Will Year-End Redemptions Kill Hedge Funds?
Investors fled hedge funds in droves in the third quarter, withdrawing a record $31.7 billion according to Hedge Fund Research Inc., and by now managers know what their end-of-year redemption requests look like, even if they're not telling. Many have already raised significant cash by selling off holdings. "But it's really a guessing game as to whether managers have created all the liquidity they need, or whether there will be massive selling through year-end," says Chris Jackson, manager of a fund of hedge funds and president of SFG Asset Advisors in San Francisco.
Some attribute the stock market's October free fall to hedge fund selling and believe the same dynamics could operate this month. Matthew Adams, director of investments at Mission Wealth Management in Santa Barbara, Calif., explains the conventional wisdom: "Hedge funds are being forced to liquidate positions not only because of investor redemptions, but also because of difficulty obtaining leverage. The result is selling upon selling upon selling, driving the market lower."
Not everyone shares this perspective, however. "Most equity long-short managers were not highly leveraged in October and hadn't been for several months," says Sol Waksman, president of BarclayHedge, a hedge fund performance tracker. Thomas Whelan, president of Greenwich Alternative Investments, a hedge fund advisory firm in Stamford, Conn., believes it wasn't hedge fund selling alone that pummeled stocks, but also tax selling by mutual funds ahead of their October 31 tax year's end, coupled with a large amount of pension plan equity unwinding in October.
For December, Whelan expects a slew of market participants, including hedge funds, to dump stocks as they re-examine the place of equities in their portfolios. Jackson suggests that liquidation pressures could continue into 2009 because some hedge funds have temporarily stopped accepting redemption requests, creating a backlog.
From the perspective of the $1.7 trillion (and falling) hedge fund industry, heavy withdrawals represent dissatisfaction with the product. "Many hedge funds didn't have much hedge when it counted," quips Jackson. Underachievers, including funds of funds, are now facing potentially large-scale redemptions and unfavorable economics where money management fees levied on dramatically fewer assets may not adequately cover fund operating costs, much less the manager's lifestyle.
Yet that's not the only reason hundreds of portfolios may soon vanish. Funds with large investment losses must rebound in order for the manager to earn his juicy performance interest, a potential jackpot that may well be his prime motivation for running the fund, says advisor Richard Lee, president of Lee Financial Corp. in Dallas. Managers may be tempted to close down beaten-up, under-sized funds, then turn around and start up new ones. "That way they don't have to recover the high watermark," says Lee.
What's an advisor to do? "We've told clients, 'If you think a run on hedge funds is a plausible scenario, get out as soon as you can because that's something you can't really protect against,'" reports Erin Scannell, the managing partner of Johnson, Scannell and Associates in Bellevue, Wash.
Those who don't flee need to take a good, hard look at their funds. Have the managers picked good securities, or dogs? Made smart decisions, or panicked? "If they're down a lot, in this environment you have to decide whether it's a manager issue or a market issue," Lee says. "You also want to see whether there is a fundamental disconnect between what the managers said they would do and what they're actually doing."
In the meantime, Lee is adding significantly to stakes in the distressed debt area, which focuses on companies facing extreme financial difficulty. "That should be one of the most opportunistic parts of the hedge fund market right now," he says.
Whatever hiccup-or heart attack-year-end redemptions cause, the industry is learning, Lee says. "Managers are rethinking how to structure hedge fund liquidity so that they can operate in a more orderly fashion."
What do you get when you put a bunch of commodities players in a room? A mix of short-term gloom and long-term boom. At least that's what the mood was like at last month's "Inside Commodities" conference at the New York Stock Exchange. The massive correction in most commodities since the sector's summer peak hasn't dented the underlying supply-and-demand fundamentals in this area. These fundamentals should propel the sector during the long haul, said various speakers, but don't bank on a quick recovery.