Hedge Fund Liquidations: Five Things You Need to Know

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?

So as a follow-up to "Hedge Funds and You: What Individual Investors Need to Know," 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.