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)) than larger amounts of a $25 stock (say Altria ( MO)). And before you know it, that $200 stock has become a $100 stock. "Classic" valuation is thrown out the window.

4. The Futures Effect

Liquidating large amounts of stock for an individual fund can be a complex task:
  • 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")

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