Hedge Funds May Be Driving The Market Selloff, But Not Because They Are Shorting

In a surprising turn of events (for some), the market sold off Monday on news that the TARP bill failed, and again today on the news that the bill passed, even with the ban on financial stocks still in place and extended for another few weeks (see WSJ article here). How could this happen? Isn't the short-selling ban suppose to put a floor on the market? Of course not, but the current sell-off of the market at a time when a ban on short selling exists for over 1,000 stocks illustrates in part how current portfolio positions are still being reduced.

So who is doing the selling? It is probably coming a little bit from everywhere, but the hedge funds in particular appear to be taking every market rally as an opportunity to sell into strength. Recent news highlights how hedge funds are experiencing a decade-worst level of performance (see WSJ article), with September possibly being one of the worst months on record for many funds, with losses expected to be between 5-9 percent on average. Such poor performance is also causing an increase in withdraws. In particular, fund-of-funds (FoF), which invest in individual hedge funds in order to diversify risk, are helping to facilitate the hedge fund redemption as some investors are withdrawing up to 20 percent of assets under management (see WSJ article). On average, FoF were down 6.4 percent in August, even worse than the already terrible 4.9 percent loss experience by individual hedge funds. The problem is significant given that FoF account for about 40 percent of the $2 trillion hedge fund market. Many FoF also make it easy to withdraw money, as opposed to most hedge funds that have longer lockups and notification periods. To compound the problem, many hedge funds also became over-weighted in energy and commodity stocks just as the market was topping this summer, and are continuing to unwind these positions. Redemption notices put in near the end of the summer are also now meeting their time restrictions and being executed. Many funds had hoped to see a recovery before any redemption requests came due, but many investors are not having second thoughts, and are going forth with withdraws. The wave of selling may continue for a while, regardless of any short-selling ban.