Hedge Fund Liquidations: Five Things You Need to Know

Futures -- especially if sold before the market opens -- can set the markets up for a nasty fall. This has the effect of yelling fire in a crowded movie theater and in investment terms, panic selling may ensue. Once futures are sold off in this dramatic fashion, traditional indexed funds are forced to sell stocks in order to adjust their holdings to the perceived discount to fair value. A self perpetuating sell-off develops and markets rapidly head lower.

5. Extreme Herd Mentality

Hedge funds tend to act as a herd. While this may be no different than how individual investors think and behave, within the hedge fund community, because of these funds' massive sizes and access to lightening fast execution programs this herd phenomena develops in a more concentrated, more leveraged and rapid manner.

While hedge funds are natural competitors with one another, they also share information amongst their brethren. Furthermore, the sell side brokers will tend to market the same trade to many of their hedge fund clients, once they spot what trades are taking place. I have seen this happen time and time again.

For example, if ABC, a successful hedge fund, is buying commodity stocks and shorting retail stocks, then a diligent salesperson will ring up hedge fund XYZ to tell them what the "smart money" is doing. This then has a multiplicative effect and before you know it the entire hedge fund industry is loaded up on the same trade.

As long as the trade works, this is great for the saleperson and for the hedge funds. However, once the hedge funds unwind these concentrated and leveraged trades -- whether having to redeem or deleverage or manage risk -- there is a massive rush to the exits. We call these "Katy Bar the Door" moments (a commonly used Wall Street phrase for when everyone is trying to exit at the same time).