Investors trying to divine the near-term future of energy stocks should consider a factor that doesn't show up in sector fundamentals: bad hedge fund returns. The problem is redemptions, which occur when a fund's returns are weak enough that investors ask for their money back. After a grim October, it's a safe bet that redemption requests are rolling in at some shops, especially since many funds require up to 45 days' notice before paying money out. An investor hoping to collect before year's end has only a few days left. The need to raise cash could add to the market's volatility, particularly in popular sectors. "Most people were long energy and short retail," said says Rick Doucette, chief investment officer at George Weiss International, a Hartford, Ct.-based fund. "If you're long energy and you see a drop of 10% in that position, as a hedge fund, you need to book your profits for the year and so you sell." While fundamental factors like lower oil prices clearly drive the space, it's possible that the unwinding of the energy/retail trade has contributed to the roughly 4% decline in the Amex Oil Index over the past five sessions, a period that has corresponded with a 3% firming in the S&P Retail Index. "If you look at how energy has performed relative to all sectors, it's been by far the best of the year, so managers are likely to take some profits off the table," says Kevin Campbell, vice president of research at Van Hedge Fund Advisors International, a research-focused hedge fund advisory firm. Most hedge funds have been hurt in October, with the bulk of the pain in strategies that focus on merger arbitrage and big corporate news events. "I don't know of any arb that wasn't down," says Nancy Havens, founder of Havens Advisors, a New York-based merger arbitrage hedge fund. She cites the failed Guidant ( GDT), Cablevision ( CVC) and School Specialty ( SCHS) deals as the leading causes of performance (although she stresses that her fund isn't anticipating outflows).
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.