“During the stock market decline (or ‘crash’) of October 2008, various media outlets have loudly identified the impact of massive hedge fund liquidations as a key ingredient to the huge equity sell-off,” Scott Rothbort reports for TheStreet.com.
Rothbort reports, “However, as an “average” individual investor, how well do you really understand how or why these mysterious investment funds have acted in such a brazen manner?”
Rothbort explores five things that you need to understand about hedge fund liquidations.
1. Meeting Redemptions
2. The FOF Effect
3. Leverage: Let’s say a hedge fund’s leverage is 5-to-1 and it’s redemption time. In order to meet those redemptions, the hedge fund will have to sell at least $5 of investments for every $1 of required redemptions. As redemptions tend to be clustered, the impact on individual stocks from hedge funds liquidating their holdings (to meet those redemptions) will be a magnified and concentrated hit on those stocks, and potentially the overall market.
Since the hedge funds are more concerned about creating liquidity than preserving the integrity of their portfolios during a crisis, the higher priced stocks tend to get sold first. It is far easier to create $10,000,000 of cash by selling smaller amounts of a $200 stock (say Apple (AAPL)) than larger amounts of a $25 stock (say Altria (MO)). And before you know it, that $200 stock has become a $100 stock. “Classic” valuation is thrown out the window.
4. The Futures Effect
5. Extreme Herd Mentality
There’ much more in the full article – recommended – here.
[Attribution: Fortune. Thanks to MacDailyNews Readers “JES42” and “Dale E.” for the heads up.]
