Hang On: Hedge Funds Aren't Done Selling

Editor's note: This was originally published on RealMoney. It is being republished as a bonus for TheStreet.com readers.

The newspapers blame the weakening economy and somber earnings forecasts for the sharp selloffs we've been experiencing. Declining earnings and recession fears play into the declines, to be sure, but the real story -- which does not get the headlines it truly deserves -- is the mass liquidation that is occurring within the highly leveraged hedge fund community.

The mind-boggling size of the redemptions -- resulting in the need to sell at any price, especially if leverage is involved -- renders obsolete even the most seasoned professional's playbook. Gaming investor sentiment and using valuation as a guide have proved to be folly in the face of the avalanche of forced selling.

The good news is that valuations will matter eventually, and the incredible amount of cash that is currently on the sidelines will be put to work. For now, though, it is imperative that investors realize that the selling we are seeing now is not the work of rational human beings. Rather, it is the result of the largest deleveraging in financial history.

Half a Trillion?

The numbers are staggering. Although estimates vary, the total size of the hedge fund industry was about $1.8 trillion at the end of the third quarter, with about a third of that controlled by funds of funds, which are notorious for their itchy trigger fingers. Redemptions in August and September were substantial, at about $60 billion according to Eurekahedge, with most of the money coming out of long/short equity funds.

The high level of redemptions, together with the negative performance, has resulted in hedge fund assets falling precipitously in the third quarter. The total decline in hedge fund assets was on the order of $160 billion. That was the third quarter. Unfortunately, the damage has been much, much worse so far in the month of October.

Although data are sketchy at this point, many believe that hedge funds are facing redemptions on the order of half a trillion dollars. This is certainly not a surprising number given the amount of money that funds of funds control, and given the fact that many absolute return strategies are losing money -- a lot of money -- institutions and individuals alike have been losing at least a little faith in the entire asset class.

They Aren't Done Yet

The bad news is that the hedge funds are not done liquidating, and the constant selling creates a vicious cycle -- a negative feedback loop -- on both Wall Street and Main Street. Funds are forced to sell as valuations move lower, and Main Street grows ever more frightened by unending incineration of wealth.

The headlines attribute each successive drop in the market averages to the latest earnings disappointment or lowered forecast, but the real story is the forced selling. The forced sales -- especially of the margined funds -- have overwhelmed the market, and the situation is only made worse as programs and humans have piled on to the downside.

Note the extreme moves at the end of each day, as the margin clerks try to give the foundering funds a chance for the market to turn in their favor. Ultimately, however, the collateral must be protected and the funds are forced to unwind their positions.

Sidelined Cash Will Be Put to Work Eventually

The good news is that many in the hedge fund and mutual fund industry have been somewhat ahead of the curve, raising cash on the way down. That means there is currently a tremendous amount of cash on the sidelines. That money at some point will move back in to the market, but so far most trading desks have not been seeing buying of any real consequence.

It will happen, though. There are a great many stocks that are trading at levels that discount the very worst of outcomes. Stable, defensive businesses with high levels of cash and prodigious amounts of cash flow are now trading at extremely low valuations. I will focus on some of those opportunities in future columns, because I am confident that investors will realize sizable gains from these levels over the next few years. So, yes, there is hope.

But for now, valuation and sentiment does not matter. It is imperative for investors to realize that and to acknowledge exactly what they are up against. This is the Great Deleveraging of 2008, the likes of which nobody has ever seen.

This was originally published on RealMoney on Oct. 24, 2008. For more information about subscribing to RealMoney, please click here.

Jeffrey Bagley, CFA, is vice president and senior portfolio manager at Davidson Trust Company in Devon, Penn. Prior to joining Davidson Trust, Bagley was a portfolio manager at McCabe Capital Managers and a sell-side analyst at Schroder & Co. and NatWest Markets. He was also a senior analyst and editor at the Value Line Investment Survey and an investment analyst at The Vanguard Group.

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