The Great Hedge Fund Unwind Is Under Way

by: Paul Kedrosky

News that Citadel Capital has had its worst year ever should be final confirmation, if needed, that the great hedge fund unwind is underway. If Citadel can't navigate the current year, then a good bet is that most current funds can't. After all, only two strategies were up in September -- short bias and macro -- and most strategies are down more than 30% for the year-to-date. The capital-weighted  performance is worse if you consider that some of the better performing strategies, like short bias, manage negligible capital.

string So, should we be worried? Happy? Other? Well, you need to understand the unwind  to understand the nonstop selling of equities going on worldwide. It's partly about revaluation in the face of long and deep recession, but the selling is also about broken hedge funds being forced to sell whatever is liquid to respond to margin calls, and equities are more liquid than anything else they own, so they get sold.

It should sound familiar. It's like what happened last summer during the quant-quake. Oodles of quant funds got smoked as heavy selling of their holdings presaged multiple hedge fund meltdowns, in particular two at Bear Stearns. Something similar is going on here under the surface, and it's much wider than Citadel. Some have called it a margin call to the system, and that metaphor feels right to me -- right down to the likelihood that it ends with the failure of a couple of hedge funds.

While I'd like to think it can happen cleanly, my belief is it can't. It's partly because too many levered funds are trying to go to cash at once, and it's partly because too many funds, trapped in illiquid positions, are selling the same stocks. And, at its worst, we have funds trying to martingale their way out, doubling down wherever they can, hoping against hope that a sharp move will cut their losses before clients yank out all the capital anyway. These latter funds are ticking time bombs, like a skein of LTCM-lites, all roiling markets in their death throes.

Welcome to the great hedge fund unwind.