I had lunch with a leading hedge fund manager over the weekend. He didn’t want me to mention his name, but he was happy to admit – in fact he went on about it at great length – that he and many of his peers have a serious problem on their hands and there’s not a lot they can do about it.

That problem is redemptions.

Now, his fund has done well. He’s been long oil, long gold and short the stock market (sure, it seems an obvious position now, but it’s surprising how few took it). Yet many of his investors are pulling their money out. And in funds where the performance has been less impressive, the rush for the exit has been more dramatic.

Why are investors fleeing hedge funds? Perhaps to cover bills elsewhere, or perhaps simply because they’re panicking. And as we all know, the golden rule when panicking, is to panic first.

But this rush for the exits is taking its toll on stocks that have nothing to do with the credit crunch…

Why redemptions can trigger a domino effect

When you invest in most hedge funds, there will be a ‘lock-up’ period – a period in which investors agree to tie up their money and not make withdrawals. Once that period ends, investors can usually redeem their stakes at the end of the next quarter, provided they give enough prior notice, usually 45 to 90 days. But in June we saw a major rush for the exit.

The trouble is, this can trigger a domino effect. If a hedge fund has to return significant amounts of cash, the manager may then be forced to sell assets to raise the money, even if he would otherwise hold on to them. But this sell-off then drives down the price of the company he’s selling, which hits the performance of his fund, which makes more investors want to pull out.

Let’s look at an example.

RAB Capital (LON:RAB) has about $6bn under management. Their founders, Michael Alen-Buckley and Philip Richards, were considered two of the most astute investors around. They understood the industrial revolution in China and elsewhere in Asia, they foresaw the great boom in commodities, and they got in early. Without their funding, much of the boom in junior mining companies that we saw in the early noughties would not have been possible. RAB made millions. However, the decision last year to buy Northern Rock(PINK:NHRKF) as it was in freefall put a sizeable dent in the company’s reputation, not to mention its bank balance.

RAB Special Situations (Aim:RSS) is one of their better known funds. It listed in 2005 at £1 a share. It’s a closed-end fund, which means that even if you sell the stock, they don’t then have to sell off a corresponding position in the underlying assets, unlike an open-ended fund. This means the fund will sometimes trade at a premium or and sometimes at a discount to the underlying value of the assets it holds (its net asset value, or NAV).

On July 8th, JPMorgan (NYSE:JPM) announced it had sold a million of its four million RSS shares. You can see what this selling has done to RSS. The fund has fallen off a cliff.

The fund is now trading at about 63p, even though it has a net asset value of 111p. That’s a big discount. It seems strange that JP Morgan would sell its position down so aggressively at such an obvious discount, but with the state that financials are in at the moment, the group may simply be keen to have as much cash to hand as possible.

The obvious trade for investors in RAB’s unquoted fund to make now is to redeem their position and buy RSS, the quoted fund. They’re effectively buying the same underlying assets at a big discount. But that would put even more redemption pressure on RAB.

How hedge funds are driving stock prices lower

In any case, one company that RAB had a significant position in is ICS Copper (CA:ICX), a nice little junior miner with some interesting copper assets in Zambia. But the Zambian copper plays have been badly beaten up this past year.

ICS has been on a near-relentless decline since August last year. In late June of this year ICS’s sell-off accelerated and the stock almost halved in a few weeks, going from 40c down to almost 20c. This happened to coincide with the second quarter hedge fund redemption season and with JPMorgan’s selling of RSS.

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Source: Why the Credit Crunch Will Hammer Stocks as Well as Property