During the stock market decline (or "crash") of October 2008, various media outlets have loudly identified the impact of massive hedge fund liquidations as a key ingredient to the huge equity sell-off.However, as an "average" individual investor, how well do you really understand how or why these mysterious investment funds have acted in such a brazen manner? So as a follow-up to " Hedge Funds and You: What Individual Investors Need to Know," let's explore five things that you need to understand about hedge fund liquidations.
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 - Get Report)) than larger amounts of a $25 stock (say Altria ( MO - Get Report)). And before you know it, that $200 stock has become a $100 stock. "Classic" valuation is thrown out the window.
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")
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.
A great example of the herd trend in action is the "carry trade." In the carry trade hedge funds will borrow money in a low interest currency and buy assets in a higher interest currency. For example, selling Japanese Yen (JPY) at 0.5% and reinvesting in U.S. Dollars at 3%. This trade works well as long as the exchange rate between the two currencies is stable. However, once the trade stops working (or as we say in the industry is no longer "setting up") or there is a coordinated exit from the trade, this will result in huge dislocations in the pricing of these assets without regard to the true fundamentals. Recall the huge rally in JPY last week, as the carry trade was unwound by liquidating hedge funds. Then noticed what happened to JPY this week, once the unwinding ceased.
Spot market dislocations related to hedge fund liquidations, as valuations become increasingly cheap and selling seems to become irrational. A great example of this type of dislocation was Freeport McMoRan's (FCX - Get Report) stock activity, which was recently subject to hedge funds liquidating en masse. Identify when futures markets are moving by wide margins, without any associated economic or fundamental news. Instead of panicking and be shaken out of the market, use these situations in an opportunistic way.