What the Hedge Funds' Bad September Could Mean for Markets

It appears hedge funds had a disastrous September, the worst since records have been kept (1990). Some of the names on the list are quite shocking as they are considered "the best of the best". The whole idea of a hedge fund is to offset market volatility and be able to make money in both and up and down market (or at least limit losses) - or at least that was the old school idea of what a hedge fund offers. The new school idea is to take as much risk, lever as much as possible, and create generational wealth in a span of 2-3 years and then if the fund blows up, oh well. You start a new one in 18 months and say "well, who could expect what happened to happened - it blew up my model".

I will say there have been some things that have worked against hedge funds of late:

1. Many long-short funds, and many quant funds, got the rug pulled out from under them with the short sale restrictions in financials, and many hedge fund strategies won't work if the rules are constantly changed - as they have been.
2. The day to day volatility as we've pointed out here is simply unfathomable - 4% days have become the norm.
3. There is no memory from one day to the next - it is impossible to make money when no trend lasts for more than 48 hours.
4. Naked shorting has finally been enforced - this was stealing candy from a baby for many hedge funds as they could sit and effectively attack smaller companies day after day for as long as they want. The investment brokers, serving as prime brokers for the hedgies, of course were laughing it up too - more profits for all of us!... until the day the tables turned on them and the i-banks became the targets. Then the last two i-banks standing ran to Washington D.C. and screamed to CHANGE THE RULES since naked shorting is UNFAIR and the Frankensteins they helped create had turned on them. It is the height of hypocrisy. But without naked shorting, the "easy trade" has been taken away from some of these hedge funds. Gaming the system is not really showing any investing acumen - it is simply skirting the rules - I hope this becomes a permanent change and we allow smaller companies to actually enjoy an existence in the stock market.

I think this era is going to show a lot of institutions who threw gobs of money at hedge funds based on "models" to rethink the situation. And just from a lot of what I read on the internet, many individual investors seem to think of these hedge funds as magical entities who are above it all and can mint money like magic -  those perceptions will also be going bye-bye.

As I've been saying, this very fat herd full of "me too" hedge funds is going to be thinned substantially in the months and year to come. Hopefully old fashioned stock picking (both long and short) makes a comeback - you know, picking stocks with good prospects to go up, and vice versa? Instead of having 450 supercomputers from this fund battling 980 super computers from that fund? I'm a traditionalist I guess.

• Maverick Capital Ltd., Greenlight Capital LLC and The Children's Investment Fund Management LLP fell more than 12 percent in September as stock hedge funds posted record monthly losses and braced for client defections.
• Lee Ainslie's Maverick Capital declined 19.5 percent and Greenlight Capital, run by David Einhorn, was down 12.8 percent, according to investors in the New York-based funds. Children's Investment, overseen by Chris Hohn in London, fell 15 percent, based on a preliminary estimate. (Maverick is very well respected and to lose 1/5th of value in 30 days is simply unfathomable; Einhorn has become a CNBC star.)
• Other managers with above-average losses for the month included Stephen Mandel, whose main Lone Cyprus fund in Greenwich, Connecticut, fell 14.7 percent. New York-based Third Point LLC, run by Daniel Loeb, dropped 11 percent.
• Stock hedge funds fell an average of 8.6 percent in September, the biggest one-month loss since Hedge Fund Research Inc. began collecting data in 1990. While that was better than the 12 percent decline by the MSCI World Index, a benchmark for global stocks, industry analysts expect investors to increase their requests to pull money from funds.
• The losses came even as many managers sought to sidestep the tumble in equity prices by holding more cash, cutting borrowing and reducing their bets on stocks expected to rise.
• Restrictions on shorting stocks in the U.S. and U.K. put in place on Sept. 18 hamstrung funds that could no longer bet on falling prices of 15 percent of the companies in the Standard & Poor's 500 Index. Energy and materials shares, which many hedge funds had been expecting to rise, were some of the worst performers in the month, with the S&P 500 Materials Index down 17 percent and its Energy Index down 12 percent.
• Price swings also made trading difficult, investors said. The S&P 500 rose or fell more than 4 percent on six trading days in the month, compared with once in the previous eight months.
• Managers including DKR Capital Partners LP in Stamford, Connecticut, and London-based RAB Capital Plc restricted redemptions on some funds so they aren't forced to sell assets at a loss to pay off investors. RAB Special Situations, down 15 percent in September and more than half this year, won investor approval on Sept. 30 to delay redemptions for three years in return for a cut in fees. DKR SoundShore Oasis Fund restricted redemptions after it received requests for withdrawals totaling 27 percent of its net asset value. Guy Wyser-Pratte suspended withdrawals from his $500 million Wyser-Pratte Eurovalue Fund.
• The month was the worst in 19 years for a basket of 50 stocks that are widely held by hedge funds, according to Goldman Sachs Group Inc.'s Very Important Positions index. The index fell 18.6 percent in September, the most since data have been tracked, and 24 percent year-to-date. The index is compiled of the positions that appear most frequently among top 10 holdings of hedge funds. (That's forced liquidation after forced liquidation - and it's a spiraling effect.)

Here is the scary stat (well, the whole story is scary)

• Funds of hedge funds probably put in more than $100 billion in year-end redemption notices by this week's Sept. 30 redemption deadline, according to London-based advisory firm Clontarf Capital.

So depending on the leverage in the hedge fund system, multiple $100 Billion x (amount of leverage in those hedge funds) and that's how much selling could potentially go on in the 4th quarter to meet redemption requests. This is why I don't expect much sustained success to the upside in markets in the fourth quarter, although I'd be happy to be wrong.

Hopefully by Dec. 31 a lot of smaller to medium funds have closed up shop, exited positions, and we can carry some semblance of normalcy beginning Jan. 1. But I'd love to be a fly on the wall at some of these offices as the "brightest and best" explain to their investors how a "hedge(d)" fund could perform quite so poorly.

Comments

[Moses:]

Good article, the flushing out of all these hedge funds is a natural correction. The days of easy money is gone and these people need to get real jobs that add physical value to the economy and not paper profits.

2008 Oct 03 04:08 PM

[Chabunga:]

The tables turn on the momentum driven quant gurus-TANSTAA F L-there ain't no such thing as a free lunch-turns out you actually have to produce something of value or truly be smarter than the herd to earn outsized returns-rare attributes in this brutal market

2008 Oct 03 04:09 PM

[honkytonker:]

Don't give the SEC so much credit. Their naked shorting rules were toothless and never meant to be enforced. The only way they could temporarily stop the naked shorting was to stop ALL shorting. They are seriously bent by the industry they are supposed to regulate. Naked shorting of Goldman into oblivion would have been nothing less than schoolyard justice.

2008 Oct 03 04:21 PM

[oldgoldbug:]

Explains some of the relentless selling - everybody in the same stocks and no one to take the other side. Really do wonder how much more selling needs to occur to satisfy redemptions.

2008 Oct 03 04:29 PM

[Distressed ...:]

how are Renaissance Technologies, and SAC holding up?

2008 Oct 03 05:33 PM

[User 236661:]

This is an ignorant rant on a site that I respect, and am surprised it was posted. Free speech I guess. I can understand the mob mentality unleashed now that markets are bleeding (yipee for those of us 100% in cash with ready ammo to redeploy). When some church leader in England called hedge funds (or was it short sellers) bank robbers who were responsible for the collapse of all those mighty banks, you know the messenger is about to be lynched.

Anyway, I digress. The term hedge funds is a misnomer. These are trading vehicles, with different strategies. It doesn't mean that when markets are down these vehicles will all be in profit. Some will fare better than others and some blow up - but on the whole I think you will find investors in these vehicles will have performed relatively better than those invested in long only mutual funds.

I sense sour grapes in you tone.... <wink>

2008 Oct 03 06:15 PM

[Jolly_Rancher:]

Actually, the hedge fund redemptions might just send some shares of smaller companies up that hedge funds have been beating down by shorting over the last year or so. Not many, but a few. Find a company with decent prospects, not so much tied to the economy,with high short interest, Bingo.

2008 Oct 03 06:17 PM

[E.D.Hart:]

Reasearch Published by Morningstar demonstrates that "on the whole, hedge funds do statistically even with the universe of long only mutual funds" before fees, after fees of course, on average, they are losers, relative to long only mutual funds.

I sense a reality check <wink back at ya>

2008 Oct 03 09:43 PM

[sf94127:]

Yes, Chris Cox finally got around to enforcing naked short selling, a practice which supposedly contributed to the Great Depression in the 30's. The more things change the more they stay the same.

2008 Oct 03 10:57 PM

[Egg:]

What would those September #s have looked like if the market didn't have the end of quarter paint the tape rally on Tuesday?

2008 Oct 04 12:39 AM

[Portable Alpha:]

I think you are slightly overpessimistic. Hedge funds, like most other entities and individuals in various respects, they differ from one another. It's normally a pyramid structure, basically only a few stand on top can beat the market/index/or whatever variable. Which is why, you supposedly elect 100 + 425 + executive branch folks to represent 300 million + people, and which is why there are established ranking system in literally every aspect of our life, i.e. no.1, no.2 and no.x investment houses and commercial banks. [I'm not giving some elitism b.s., just a statistical fact with common sense] Hence, hedge funds are no exception, they are human beings as well, just slightly better informed, more motivated and fairly well compensated, but as you've implied they are not much different than common folks anyhow.

My point tho, it's imperative for investors and money managers to stay put and not panic. Easier said, I know, but that's pretty much the key, well, on top of being able to think outside the box and inside of it, as well as combining composure, flexibility and adaptability to beat the stress and whatever else that shall be beaten.

2008 Oct 04 01:42 AM

[User 237841:]

"Funds of hedge funds probably put in more than $100 billion in year-end redemption notices by this week's Sept. 30 redemption deadline, according to London-based advisory firm Clontarf Capital."

This shouldn't be a problem if the following is true. (And why shouldn't it be...hedge funds no doubt have been selling all the way down!)

seekingalpha.com/artic...


"Citigroup analysts already estimate that hedge funds have around $600 billion in cash reserves in anticipation of redemptions."

2008 Oct 04 10:33 AM

[Jimbo:]

This post is certainly consistent with my take on naked shorting. It seems to me if you sell something you don't own, you re committing FRAUD. I have read that some of these short sales are more than 200 days overdue for settlement. If true, this is PIRACY! I am going to e-mail Porter Stansberry and tell him to read this post, since he is such a big fan of all kinds of shorting.

2008 Oct 04 11:07 AM

[Urbane Gori...:]

I've come across the issue of more pain to come before the end of the year due to the redemptions. I'd be interested in opinions on buying solid equities (good cash flow, growth in earnings, debt/equity ratings of less than 3%, etc) with very little Institutional investment, that are trading low in sympathy with stocks that got hammered in the hedge fund selloff.

My thinking is that if they don't have a remaining large institutional base, and do have a good cash situation, might they not only suffer less, but rebound faster and higher?

John (Glass is half-full) Egan ;-)

2008 Oct 04 03:47 PM

[Market Folly:]

more september hedge fund performance #s: www.marketfolly.com/20...

and more on deleveraging, redemptions, etc: www.marketfolly.com/20...

2008 Oct 05 02:10 PM