Hedge funds add to markets' pain

The great unwind in the secretive hedge fund world caused by steep losses has contributed to the megapain in the stock market.

Wealthy folks and big investors yanked a record $31 billion to $43 billion out of hedge funds in the third quarter, according to estimates from tracking firms Hedge Fund Research (HFR) and TrimTabs. As a result of ongoing redemption requests from worried investors, the so-called smart-money crowd has been forced to sell assets to raise money to pay back investors.

That vicious cycle of forced selling by these private investment funds has exacerbated the heavy pressure that has pushed the U.S. stock market down as much as 43% from its October 2007 high. "It is really like a global margin call. It feeds on itself," says Woody Dorsey, president of Market Semiotics, which specializes in behavioral finance.

Big losses

Unlike the 2000-02 bear market, when hedge funds posted overall gains amid a broad market meltdown, this time around they are suffering big losses. The average hedge fund posted a 5.7% loss in September, the worst month on record, Merrill Lynch says.

The funds continued to lose money in October, falling 3.8% more through Oct. 10, extending the year-to-date losses to 15.9%, Merrill says.

While that loss is far better than the 38.8% drop in the Standard & Poor's 500 that same period, it puts the hedge fund industry on track for its first down year since 2002, when the average fund fell 1.5%, HFR says.

Hedge funds typically market themselves as being able to make money in down markets.

Hedge funds "are not the sole culprit" for the selling vortex that has swamped markets since the beginning of October, says Jim Dunn, managing director at Wilshire Associates. He says mutual funds, pension funds and sovereign wealth funds also have been pulling money out of the market.

Record cash stockpile

Still, hedge funds now have their largest cash positions ever. An estimated $184 billion, or about 9% to 10% of total industry assets of about $2 trillion, is now sitting in cash, Merrill says. (Citigroup estimates that hedge fund cash might be as high as 20% to 30% of assets.)

Richard Baker, CEO of the Managed Funds Association, says the record cash stockpile is partly to meet redemptions. But, "Part of the intention is to park cash until opportunities arise," he says.

Hedge funds, which use borrowed money to amplify returns, have also had to raise more cash to meet so-called margin calls by brokers who require more collateral as asset prices drop. This process is called deleveraging.

Even one of the hedge fund's biggest funds run by a superstar manager is having a tough year. Citadel Investment Group's flagship Kensington Global Strategies fund, run by Kenneth Griffin, was down 26% as of Oct. 15, according to an e-mail Citadel sent to shareholders on Wednesday.

The pressure on hedge fund managers is likely to continue until the panic phase of the market ends. "That phenomena is still with us and likely to be with us until the pressure of investors saying, 'I want all my assets in cash' " dissipates, says Kenneth Heinz, president of HFR.