Hedge Fund Liquidations: Five Things You Need to Know

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 Apple (AAPL Quote)) than larger amounts of a $25 stock (say Altria (MO Quote)). 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. (Don't miss "Five Things Every Investor Should Know About Index Futures")