Hedge Fund Redemptions and Volatility

According to Dow Jones, the event-driven hedge fund index in October was down 2%, reducing its year-to-date gains to 3.54%. That isn't the kind of return many fund investors expect and will almost certainly lead to redemptions. Meanwhile, the pain that has built up all year in several other strategies, particularly convertible arbitrage, will also lead to redemptions in those funds and could conceivably make the volatility worse.

The impact of redemptions is part of a larger debate on Wall Street about the role of hedge funds in market volatility. Some analysts say that while hedge funds can temporarily exacerbate price swings, on the whole, they do as much to reduce volatility as to create it.

Hedge funds are often liquidity providers, taking the other side of esoteric hedging trades and keeping companies honest through their willingness to go short. But when mutual fund managers, institutional investors and hedge funds are all bailing out of a trade, the impact of hedge funds on the market tends to be significant.

"Even though most of the time, hedge funds have a dampening effect on volatility, it is fair to say that in recent days, they have contributed to the recent fall in energy prices," says Justin Dew, a hedge fund analyst at Standard & Poor's.