The sharp market declines on Wednesday that were exacerbated by rumors of poor performance at a leading hedge fund may only be the tip of the iceberg, as heavily leveraged funds are forced to liquidate more assets.


Dow Jones Industrial Average

plunged 733 points Wednesday as reports circulated that a key fund run by Citadel Investments, a large, Chicago-based hedge fund, was down more than 30%. Citadel acted quickly to dispel the rumors, but acknowledged that challenging market conditions last month had led to the worst performance in its history.

Wednesday's decline was the latest in a series of enormous dips and peaks in the market, as it has swung wildly on uncertainty about underlying fundamentals. But deleveraging, short squeezes and automated trades have also come to play a huge role in exacerbating gains and losses. Hedge funds that use borrowed money to amplify their bets and byzantine derivative investments to offset losses are contributing mightily to the off-the-charts volatility.

"Hedge funds are the most active part of the market, they do the most transactions," says K. Daniel Libby, senior portfolio manager of the Select Access hedge funds for Sands Brothers Asset Management. "Furthermore, as a backdrop, there's less trading going on generally in a lot of sectors of the market, and people everywhere are holding greater amounts of cash. Therefore, the impact hedge fund managers are having is even more pronounced in a market such as this for those hedge funds who are executing transactions."

All told, the Dow has varied 3,250 points so far this month, from a height of 11,022.06 on Oct. 1 to a low of 7,773.71 on Oct. 10. Components like

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traded under 52-week lows on Thursday.

Such instability can create a negative feedback loop of further panic, further withdrawals, and yet more volatility. A recent report from TrimTabs CEO Charles Biderman says that hedge funds have seen inflows slump dramatically after losing 4.6% through August, "by far the worst performance since our records begin in January 2001." During that period, inflows dropped 63% to $84.1 billion from $225 billion a year earlier, and Biderman expects "sizeable outflows" in September and October.

Michael Corcelli, managing member of Miami-based hedge fund Alexander Alternative Capital, says insecurity about the stock and bond markets is moving many investors to pull their money from funds or, in other cases, triggering an automatic forced deleveraging if certain performance barriers are broken.

"There are no ifs ands or buts about it," Corcelli says. This forces hedge funds that are leveraged -- up to 10 times, in many cases -- to liquidate positions to raise cash.

Alexander Alternative Capital hasn't used leverage since early 2007, according to Corcelli, though other hedge-funds are leveraged on multiple levels. That's especially true for high-net-worth individuals, family offices and hedge funds of hedge funds, who sought to diversify and boost returns with what was expected to be a little extra risk. Such investors typically bring their millions to a bank, which first creates a synthetic call option to track the performance of 20 or more funds with enhanced leverage to boost returns. Then banks hand over the cash to an array of hedge funds -- perhaps dozens -- which leverage the money a second time.

"The reason there is so much fear in financial markets today is that you have all this leverage on top of even more leverage," says Corcelli. "Then you have retail investors who are panicked, you have hedge funds who want to hold their positions but they can't because it's not written inside the private placement memorandum."

Corcelli notes that the trend is creating "huge shortfalls" in pension funds and individual retirement accounts, which could ultimately hurt taxpayers.

The poor performance of derivatives that are linked to troubled assets is also playing a big role in the forced deleveraging. Derivatives were intended to be a contract to hedge risk against unexpected changes in a variety of assets, including equities, bonds, commodities, currencies or interest rates.

As speculative investors, including hedge funds, took a more prominent role in the derivatives market, its size has ballooned. Spreads on Citadel's credit default swaps insuring the hedge fund's debt have widened -- meaning investors sense a higher risk of default -- as mortgage troubles spread from subprime up to prime loans. There are fears that Citadel clients will be demanding redemptions at the next opportunity.

Muriel Siebert, a former superintendent of banking in New York State who now runs a discount brokerage firm, says that more transparency is needed in the derivatives market, which is largely unregulated.

"It can affect the volatility, because

speculators can be trading them wildly instead of what they have been designed to do," says Siebert. "They were not meant to be traded actively, they were meant to be a contract between two people, period. Then they became more sophisticated. There's no problem with more sophisticated products, as long as we know who is trading them and how they're being used."

Siebert fears that without more transparency and some form of regulation, individual investors will remain averse to investing in equities, making capital raises more difficult. This could hinder businesses' ability to expand, develop new products and remain competitive.

Adam Lerrick, a visiting scholar with the American Enterprise Institute for Public Policy Research, says investors should be prepared for a "bumpy ride" until there is more clarity on how government initiatives will be structured, and the effects they will have on the financial sector and broader economy.

"In a crisis, technicals become fundamentals," says Lerrick. "Volatility is extraordinary because the markets are not liquid. So, when someone buys or sells in any significant size, prices change dramatically."

But even in a panic-driven environment, some find opportunities.

New York-based hedge fund SYW Capital Management has bucked the market's downward trend this year, gaining about 70% so far, according to Chief Operating Officer Andrew Lee. The firm has shorted financials while taking advantage of the alternative-energy upswing, and predicting the rise and fall of commodity prices ahead of the market's move. The fund is also long in some health-care names, because of what Lee characterizes as "significant mispricing."

Still, SYW, which runs about $50 million in assets, has gone through a significant deleveraging of its own. It now holds 50% in cash. Lee expects more pain ahead, as the mutual funds keep deleveraging huge blocks of assets over an extended period of time. He notes that while hedge funds have a sharp impact, they account for about $2.5 trillion in assets, while mutual funds account for $10 trillion in the U.S. and $33 trillion globally.

"I don't think anyone's saying that it's hunky dory when the market recovers 1,000 points in one day," says Lee. "No one's buying back into the market because they think fundamentals have improved. There's a pretty big consensus out there that things are going to get worse before they get better."

That view "gives us solace to be net short," he adds. "But you still have to be very nimble in this market."