U.S. Markets Absorbed Billions in Redemptions and Still Rose - Cause for Rejoicing?

In the secretive world of hedge funds, coddled by a cozy lack of transparency and regulation, it’s impossible to know what their exact numbers are. According to the “April 2009 Asset Flow Highlights”, however, the best estimates are that since Q3 2008, there have been net investor redemption requests of $815.3 billion from the hedge fund industry.

During that time, poor performance reduced assets by an additional $425 billion. (And that includes the fabulous rally of March and April.) Industry assets have fallen an estimated 45% or so from the peak in Q2 2008 of near $2 trillion, sliding to somewhere nearer $1.1 trillion today.

Cause for rejoicing, you think? A show of strength, right? After all, on the surface, the U.S. markets have absorbed $815 billion worth of redemptions and still risen convincingly from 6 March through today.

Uh-oh. Things are not always as they seem. We have clients at Stanford Wealth Management who are / were also limited partners at hedge funds. Most have demanded what remains of their money back, so the hedge funds have to consider that a redemption – but the stocks and bonds haven’t been sold and they haven’t been paid yet.

That's because many hedge funds have so many redemption demands that they can no longer continue as a going concern. It is essential to understand that these “non-redeemed redemption requests" have created a massive overhang of sell orders just waiting to be filled.

Sometimes we members of the public are smarter than institutional money. But if hedge funds hired the best and the brightest, and if individual investors are approaching “irrational exuberance” territory, this may be a case where the smart money is selling, under pressure from their former shareholders / limited partners, to those clamoring to buy today -- with the market up 30% without a rest.

I can’t find any credible analysis of just how much of that $815 billion has actually been paid out and how much remains. But my friend and MARKINT (Market Intelligence) colleague James Rickards is legal counsel to a number of hedge funds. He explains why we are likely to see additional intense selling pressure the moment the market shows signs of any weakness:

The hedge fund non-redemption scenarios are real inside baseball and not understood at all outside the industry… The early redeemers get cash and the last guy out gets ashes. Everyone knows this so they all want to get out at once… The ‘solution’ is to call a ‘suspension’ and stop all redemptions so that the portfolio can be unwound in an orderly way and all investors get a pro rata share of the cash… Now everyone gets a little cash and spoonful of ashes. So far so good.

What people don't understand is that once you suspend, you are no longer a going concern. This is because investors who put in redemption notices which are not honored are no longer investors. By operation of law and accounting rules they are ‘converted’ to creditors for the unpaid redemption. The manager of an insolvent fund has a strict fiduciary duty to creditors, which is higher than the duty owed to limited partners.

As a result, the manager is now on one side of the market only. He can sell… but he cannot buy (because that is at odds with his obligations to his new ‘creditors.’)

…Now, as a trader in this situation, you would do the same thing I would do. Wait out the declines and sell into rallies as long as you can. What you are left with is an enormous overhang; all on one side of the market.

I can’t say with certainty that hedge funds' forced selling will drive the market lower. I can’t say with certainty that the market will go lower, and neither can anyone else. But there are sure are a lot of bankers, brokers, hedge fund managers, CEOs, CFOs, government leaders, and talking heads out there who are trying to pipe sunshine into our lives. That makes me long for the occasional cloudy day just to make sure the sunshine isn’t artificial.

Disclosure: We are 90% cash and short-term bond funds; 10% in gold and inverse ETFs .

Comments

[TeresaE:]

Nice take on yet one more aspect of this fiasco that has not played out yet.

Green shoots.

Jun 03 08:52 AM

[Joseph L. S...:]

Thank you. It's an aspect too little-known, I believe...
JS


On Jun 03 08:52 AM TeresaE wrote:

> Nice take on yet one more aspect of this fiasco that has not played
> out yet.
>
> Green shoots.

Jun 03 08:07 PM

[ain't no fo...:]

Joe, thanks for the peek into one more little aspect of the hedge fund world that never saw sunlight... until NOW.

I'm not sure its our LIVES per se that those guys are trying to pipe however... maybe just a certain part of our anatomy.

Jun 03 09:05 PM

[koolsool:]

The market crash from July 2008 to March 2009 was hedge fund redemptions & deleveraging. They did tremendous damage to peoples 401Ks & pensions. A lot of people can not retire now. I was hoping the hedge funds were done.

Jun 03 10:16 PM

[Moon Kil Woong:]

Interesting take on collapsed hedge funds. What a mess. Is there a liquidation time frame or is it like banks with overhandging housing where they can sit on it forever and then lie about it's net worth on their balance sheet.

Jun 04 01:40 AM

[Joseph L. S...:]

Mr. Moon, I wish I could tell you there is a limited time in which this must be resolved. But it will move at the speed of threats, cajoling and litigation. And we all know how efficient and clog-free the civil courts are. Since the hedge fund managers are still getting their 2% fee for as long as they can hold on, many will stretch it as many months or years as they can... You've cut right to the crux of my concerns here.


On Jun 04 01:40 AM Moon Kil Woong wrote:

> Interesting take on collapsed hedge funds. What a mess. Is there
> a liquidation time frame or is it like banks with overhandging housing
> where they can sit on it forever and then lie about it's net worth
> on their balance sheet.

Jun 04 10:53 AM

[Joseph L. S...:]

Thank YOU, wpdragon, both for your comment and for catching my oblique reference. I couldn't say which part of the anatomy in a family publication like SA! //grins//
Joe


On Jun 03 09:05 PM wpdragon wrote:

> Joe, thanks for the peek into one more little aspect of the hedge
> fund world that never saw sunlight... until NOW.
>
> I'm not sure its our LIVES per se that those guys are trying to pipe
> however... maybe just a certain part of our anatomy.

Jun 04 10:55 AM