Hedge fund share sales may push share prices lower.
Today's the day the hedge funds get their sick notes. From investors feeling too sickened by market queasiness to stomach staying in.
Let me explain. Today is the last chance for people with money in hedge funds to give the standard 45 days' notice to withdraw it ahead of the fourth quarter. Such withdrawals could trigger further share price falls.
Before we go any further let's look at what hedge funds actually do.
The term 'hedge fund' covers a variety of investment vehicles, involved in a wide range of different assets like bonds, commodities and, of course, shares. Some are 'long' funds, that is to say they hold pools of assets with the intention of making profits out of them, whilst others go 'short', i.e. they sell things they don't own in the hope of buying them back later at lower prices.
And most of them borrow money to fund their investments.
Tomorrow, hedge funds with 45-day notice periods get their own financial health check. The managers will discover exactly how much money they must come up with to pay off departing investors.
And at some point over the next six or so weeks there could be chunks of shares unloaded onto the market from sources that, previously, have been very significant in driving up stock prices.
Will this lead to more market jitters?
Realistically, it could. We have heard a great deal about hedge fund losses over the last few days, in several cases caused by crunching falls in the values of some of their more risky investments.
And the real danger is the high degree of leverage employed by many hedge fund managers. In other words, as I have already explained in previous articles, the amount of shares bought on borrowed money.
It's not uncommon for hedge funds to be 20 times leveraged.
Yes, read that again. 20 times. Great if everything's going up, but potentially horrendous if asset prices fall.
Who's most vulnerable? Most analysts believe the two types of hedge fund likely to be hit hardest by redemptions are those with US sub-prime exposure and also quantitative funds. Other commentators forecast that the so-called "hot money" funds, often managed by Swiss-based funds of hedge funds, will switch from the worst hit areas into less leveraged funds.
Any securities connected US 'sub-prime' mortgages are clearly not worth anything like what they were. Nor are they likely to be very saleable. Certainly at anywhere near the prices the hedge fund managers would like to get for them.
An even worse problem emerged last week when BNP Paribas described its hedge fund glitch with another glorious financial euphemism: 'asset valuation difficulties'.
Doesn't sound like the sort of stock you or I would want to buy.
That leaves the things that can be sold. Like holdings in higher quality bonds or more liquid blue chip companies where any necessary cash can be raised without having to resort to "fire sale" tactics.
How bad will the hedge fund pull out be? No investor wants to be locked in. Troubled funds could freeze the ability of their holders to redeem their money, imposing so called "gates", in order to avoid having to dump assets at falling prices.
So nervous hedge fund investors could well make a rush for the exits.
We've already seen the sort of damage that hedge funds can inflict on share prices last week when markets round the world were hammered.
Not all hedge funds operate a 45 day notice period and not every hedge fund manager will go into sell mode tomorrow. Many managers have already cut back their borrowings to free up cash for possible withdrawals. But expect a lot more stock market volatility.
More:Is The Crisis Over? | Over Borrowed And Over There
