Hedge Funds -- The Next Problem?

From CNBC:

First, the money rushed into hedge funds. Now, some fear, it could rush out.

Even as Washington reached a tentative agreement on Sunday over what may become the largest financial bailout in American history, new worries were building inside the nearly $2 trillion world of hedge funds. After years of explosive growth, losses are mounting — and so are concerns that some investors will head for the exits.

No one expects a wholesale flight from hedge funds. But even a modest outflow could reverberate through the financial markets. To pay back investors, some funds may be forced to dump investments at a time when the markets are already shaky.

The big worry is that a spate of hurried sales could unleash a vicious circle within the hedge fund industry, with the sales leading to more losses, and those losses leading to more withdrawals, and so on. A big test will come on Tuesday, when many funds are scheduled to accept withdrawal requests for the end of the year.

“Everybody’s watching for redemptions,” said James McKee, director of hedge fund research at Callan Associates, a consulting firm in San Francisco. “And there could be a cascading effect, where redemptions cause other redemptions.”

Hedge Funds utilize a securities law that basically states a money manager does not have to register with the SEC if he only sells to "accredited investors." The standard definition for this is a person with $1 million in net worth or $200,000+ year in income for two years in a row (it might be $250,00). By only selling to these people, hedge fund managers don't have to make reports to the SEC. That means we have no idea how much money is actually invested in these vehicles or what investments they own.

There are several other important points. Most hedge funds have a policy that states a person can't simply withdraw money, but can only do so after a specified period of time like 1 year. In addition, some hedge funds only allow people to withdraw at the beginning of the quarter or month etc... That means a hedge fund could experience a flood of redemptions within a short period of time.

Here's the nightmare scenario. Fund A has a poor quarter. A bunch of people redeem shares. This forces Fund A to liquidate a large position in security X, causing security X to drop in price. This leads to Fund B taking a hit and the cycle repeats itself over and over again, essentially showballing downhill.