So begins the great hedge fund shakeout?
The maxim that hedge funds do well in times of volatility is dead. Some do, most dont. “Down 10 per cent is the new flat” one hedgie tells the FT’s hedge fund correspondent James Mackintosh.
Hedge funds, reports the FT today, are facing their worst year on record.
Witness:
The graph is from Christine Williamson at Pension’s & Investment magazine (HT Salmon):
The biggest performance dispersion among hedge funds and funds of funds in six years has set the stage for what some predict will be a six-month-long bloodbath.
A bloodbath which begins today. Yesterday was the final day (end of quarter) for investors in most hedge funds to file requests to redeem cash by December. Given the huge variance in perfomance, those redemptions are expected to be rather significant. Estimates vary, but most are in the hundreds of billions.
Citigroup analysts estimated a few weeks ago that hedge funds were holding around $600bn in cash or cash like instruments in anticipation of upcoming redemptions. That is a vast amount of money. Merrill Analysts on Monday put the figure lower, at around $184bn, but still, it’s a lot.
But is it enough?
As investors redeem, hedge funds without the cash on hand will of course be forced into asset sales. Asset sales which will further disrupt global markets. If the process is messy - and given the leverage involved, how could it not be - then hedge funds could be expected to outright fail too. With that in mind, surely banks will be increasing haircuts on credit lines across the board. Which will make the process messier yet.
Even if the majority of hedge funds have been prescient, and built up cash reserves, the implications for the market are still worrying. A significant proportion of “cash” holdings - around 17 per cent according to Citi - are in money market funds. Which really, really don’t want to be facing redemptions right now either.
And of course, the loss of business in the medium-long run for Wall Street’s brokerages will be huge.
The bottom line, according to industry outfit hedge fund research, is that up to 2000 hedge funds can be expected to be liquidated in the coming months. Given the complexity of the market - the way hedge funds and their holdings so interlace the financial system, this is a potential massive shock. It almost makes the failure of Lehman pale into insignificance. The Lehman collapse will be worked out over years. Hedge fund redemptions and liquidations will take days or weeks.
The authorities are panicked by runs on the banking system, but they might be blindsided by a far worse run on the shadow banking system - one which is beyond their control.
Nouriel Roubini wrote as much in the FT last week. It’s worth reiterating:
The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken excessive risks with high leverage and are poorly managed may collapse. A massive shake-out of the bloated hedge fund industry is likely in the next two years.
