The Mighty Hedged Funds on SALES!

At the end of October last year 2007, the FTSE 100 was 6,721. Just a year later, and now the index is 3,890. That’s a fall of 42%!

US, London and Japan stocks are far from alone. Share prices have plunged round the world, and have recently fallen so fast that there’s the smell of blind panic around. What’s more, now the great and the good among the politicians and central bankers are competing with each other to tell us how bad the recession will be, and how long it will last. In other words, this might seem to be about as bad as it gets – Sir John Templeton’s fabled point of “maximum pessimism” - which is just when contrarian investors start coming into their own.

But while sniffing out shares that have fallen right out of favour isn’t too difficult right now, there’s a much bigger problem out there. Hedge funds are in forced sale mode! Stock markets may be in fire-sale territory (even longer-term bears such as Jeremy Grantham believe stocks are now closer to being undervalued) but a lot of the big sellers are the hedge fund managers. They bought stocks with borrowed money, and are now having to offload them.

While we can’t yet know exactly what’s being sold, we do know there’s plenty more stock still in the pipeline. The hedge fund industry has been staggering through its worst time in two decades, with an average loss of 17% this year. That beats the performance of most global stock markets, but it’s still not exactly great for a concept that was supposed to be able to sidestep declining markets (though to be fair, ‘short-selling’ bans haven’t helped recently).

Now the heat is really being turned up. Some 8,000 hedge funds with more than $1.7 trn in assets are “being caught in a vicious cycle” say BusinessWeek’s Matthey Goldstein and David Henry, “as worried investors pull out their money”. The problem lies in the mix of plunging markets and massive de-leveraging, i.e. paying down debt, across the financial system. Over the three months to September, another $179bn was wiped off the value of hedge fund assets by falling asset prices, according to Hedge Fund Research.

Spooked by the market falls, and keen to have ready cash at hand, investors have been pulling their money out at a rapid rate, with almost $31bn being withdrawn over the quarter – which means hedgies need to sell more assets to repay clients. On top of this, as markets fall, lenders are also cutting credit lines to their hedge fund customers or are making ‘margin calls’, i.e. demanding that those funds come up with extra cash to back up their borrowings.

And as if that wasn’t enough, the Lehman Brothers bankruptcy is still tying up tens of billions of dollars-worth of hedge fund assets. Lots of money managers had “parked” cash and other securities at the investment bank's prime brokerage operation. But these accounts are now frozen.

But it’s about to get even worse...

That’s more than enough bad news for any industry to cope with. As many as 30% of hedge funds will be shutting up shop “in a Darwinian process”, says Emmanuel Roman at GLF Partners, and the US authorities will force-feed regulation onto the rest: “there need to be scapegoats, and they are going to go hunt people”. That will make business even harder, and lead to even more forced selling.

In London, out of 450 hedge funds, more than 100 could be at risk, says Miles Costello in The Times. New York Professor Nouriel Roubini, who has been spot on about how bad things were going to get, agrees that hundreds of hedge funds will fail. “We've reached a situation of sheer panic. Yet I fear the worst is ahead of us. Don't be surprised if policy makers need to close down markets for a week or two in coming days”. This is pretty apocalyptic stuff. But the cavalry isn’t about to appear over the horizon.

US Treasury Secretary Henry Paulson confirmed to Bloomberg yesterday that unregulated firms like hedge funds won't initially get government aid as “we're focused on regulated financial institutions.” So “you can argue that it could be worse than Wall Street because no one is coming in to save the hedge funds”, says Hank Higdon at Higdon Partners.

Why you shouldn't go bargain hunting just yet? What does this mean for the ordinary investor?

Well, because of the hedgie effect, share prices could easily fall some way further than anyone expects. “The market’s going to overshoot on the downside”, says Peter Boockvar at Miller Tabak, who sees the Dow tumbling to 5,000 next year, more than 40% below today. “When that occurs, I’ll be a raging bull”. So it’s a brave man, or woman, however contrarian, who’s prepared to dip more than a very small toe in the market with the hedge funds in forced sale mode for some time to come. I certainly wouldn’t be buying any funds, passive or actively managed.

Period.