Hedge funds at risk of mass withdrawal

Having suffered average losses of 10 per cent in the last year, managers have been bracing for a rush to cash, writes Proinsias O'Mahony

THE BELEAGUERED $2 trillion (€1.45 trillion) hedge fund industry is facing a wave of withdrawals as risk-averse investors run to cash, sparking fears that a rash of under-performing funds may collapse in coming months.

With most hedge funds clients looking to have their money returned before the end of the year had until this Tuesday - the end of the third quarter - to submit withdrawal requests.

Having suffered average losses of 10 per cent in what has been the worst year for hedge funds in two decades, managers have been bracing themselves for record withdrawals. A rising number of funds have temporarily banned customers from redeeming their cash after being inundated with redemption requests.

Many funds are expected to close in the coming months. A recent report by Cook Pine Capital, a US firm that invests the money of wealthy clients in hedge funds, estimated that as many as 2,000 funds - 20 per cent of those currently in business - could fold as the industry is reshaped.

The recent restrictions placed on short selling of stocks appear to have exacerbated the situation, with the average fund falling by 5 per cent in September alone. Not only has the ban deprived managers of one of their most lucrative strategies, it has prevented more commonplace arbitrage trades.

Andrew Baker, deputy chief executive of the Alternative Investment Management Association, this week called for the ban to be scrapped "as quickly as possible". Exposure to Lehman Brothers has also badly hit the industry.

Hedge fund performance is far from uniform. The top 10 per cent of funds have delivered returns in excess of 50 per cent over the last year. The bottom 50 per cent are down by more than 25 per cent.

With the massive increase in volatility this year, that extra leverage has resulted in eye-popping returns for some and huge losses for others. This huge variance in performance is expected to result in massive outflows from disgruntled clients. A recent survey found that 81 per cent of investors with $1 million or more in investible assets plan on withdrawing money from their current adviser.

While many may have scant sympathy for those who made big bets and lost, hedge fund failures on a grand scale could have systemic consequences. The fall of Long Term Capital Management (LTCM) in the late 1990s nearly led to the collapse of the international financial system and many investors worry that unwinding of positions by hundreds or even thousands of funds at the same time could result in chaos.

Global markets could be shaken if funds are forced to dump stocks and other securities in order to meet redemption requests, with some commentators speculating that widely held hedge fund stocks like Apple, which fell by 18 per cent amid Monday's carnage, could be hit.

One consolation is that hedge funds have been building up their cash reserves in anticipation of mass withdrawals. A recent Citigroup report estimated that hedge funds had a record $600 billion in cash, or around 30 per cent of their assets. A separate Merrill Lynch report arrives at a very different figure - a cash balance of $184 billion - but Merrill too notes that hedge funds have been cutting leverage and that cash levels are historically high.

The Citi report observes that around 17 per cent of this cash is in money market funds. The recent market bedlam saw a number of supposedly ultra-safe money market funds "break the buck" after a run on funds and the last thing authorities want to see is another wave of redemptions.

The ramifications, if any, of mass hedge fund redemptions are likely to become clearer in coming weeks and months. Typically, clients have to sit through a 45-65 day waiting period before having their cash returned to them.