Hedge Funds–A Disaster Story that Could Unfold in Quarterly Episodes

One of the consequences of the collapse of the credit bubble and the subprime lending fiasco in particular is with hedge funds. There is a substantial risk of uncontrollable instability in hedge funds that could potentially be disastrous for investors. This instability will likely be seen in waves of bad news that will come roughly once a quarter.

First, let me provide a bit of background:

1.) Most hedge funds have rules that allow only quarterly redemptions (“cashing out”) by by their investors. (A few hedge funds even have only one annual redemption “window.”) Typically, the redemption requests must be filed 45 days before the end of any given quarter.

2.) Most hedge funds have rules that allow them to suspend redemptions, at the discretion of the fund manager or their board of directors. This is just what Bear Stearns did with their funds that went under. United Capital Asset Management did the same back in July, for their Horizon Fund L.P., Horizon ABS Fund L.P., Horizon ABS Fund Ltd. and Horizon ABS Master Fund Ltd. (“Horizon”).

3.) Hedge fund portfolios can change radically, almost overnight. This can be either good or bad. If back in the middle of the year a fund manager was wise, he would have minimized or eliminated his Collateralized Debt Obligation (CDO) positions. But, on the other hand, if he was willing to take a risk, to increase yields he might have have increased his CDO holdings in chosen tranches that didn’t have exposure to sub-prime real estate lending.

My personal prediction is that for at least the next year, there will be successive quarterly waves of hedge fund redemption suspensions and perhaps some spectacular hedge fund collapses, with the news breaking in the first two weeks of each quarter. (The first two weeks of November, the first two weeks of January, the first two weeks of April, and so on.)

Fear, Uncertainty, and Doubt (FUD)
The investors in hedge funds place a tremendous amount of trust in the fund managers. This is because the fund managers are generally given free rein to regularly re-invest all of the fund’s assets in the most profitable investments. Sometimes a hedge fund can be almost totally re-invested in a different venture very quickly. For example, investors might assume (based on the previous quarter’s report and the manager’s newsletter) that the fund’s portfolio is heavily in European bond derivatives and the Yen Carry trade. But then then when the next newsletter issue is released, they may learn that 80% of the fund portfolio was shifted into corporate stock derivatives, during a leveraged buyout (LBO). The current economic and finance climate is so darkly clouded with Fear, Uncertainty, and Doubt (FUD), that it is likely that a substantial number of hedge fund investors will make a hasty exit, while the exit door is still open. I suspect that news of these redemptions will inspire additional investors to also cash out, in a cascading effect.

I cannot say with certainty that there will be a hedge fund panic, but ever since the Bear Stearns meltdown, the likelihood has definitely increased.

For any SurvivalBlog readers that hold hedge fund investments with any CDO exposure: If you aren’t sure about your hedge fund’s exposure, then you are better off getting out, pronto. (You probably should have submitted your cash out order in before August 15th.) If you wait for a quarterly report, it will probably be too late, since your quarterly redemption window will probably close before you see the report. And before the next redemption window opens the fund might suspend redemptions.