Right now, hedge funds are engaged in forced selling on an unprecedented scale. That makes a lot of investors anxious; they attribute massive market swings to these mavericks of the investing world, and they expect more to come. Here's why individual investors should be looking to exploit this trend, rather than cowering from it.

Why hedge funds sell when they shouldn't (or "the limited partner is always right")
All but the most sought-after hedge funds typically offer their investors ("limited partners," or simply 'LPs') the possibility to withdraw their assets on a quarterly basis. If the hedge fund managers don't have the cash on hand, they are forced to sell some of their holdings in order to meet investor redemptions.

I repeat: They are forced to sell.

They aren't selling stocks that have become overvalued, or because the company's fundamentals have deteriorated, or perhaps because they've decided that their decision to buy the stock turned out to be flat wrong. They're selling for one reason: Their investors demand the cash.

(That's an example of what superinvestor Seth Klarman refers to as non-economic selling -- the seller is acting for reasons that aren't intrinsic to the investment, but stem entirely from outside factors.)

$150 billion in redemptions, $400 billion in forced sales
Hedge fund selling isn't likely to be a flash-in-the pan phenomenon, either: JPMorgan estimates that investors could withdraw $150 billion from hedge funds in the coming year. However, because funds typically use borrowed money to amplify their returns, that $150 billion in investor assets may represent a substantially higher amount of fund holdings in need of liquidation. JPMorgan estimates that $150 billion in redemptions could result in asset sales of $400 billion.

Now, $400 billion might seem like a piddling amount – it's less than 5% of the market capitalization of the S&P 500, and less than 3.5% of the total market value of all U.S. equities (as measured by the Dow Jones Wilshire 5000 Index). And that assumes that JPMorgan's estimate referred only to equity hedge funds (which it didn't).

The thing is, hedge fund ownership isn't distributed evenly. For example, there are 85 stocks for which either (a.) total hedge fund ownership exceeds 18%, or (b.) a single hedge fund owns at least 8% of shares outstanding (for stocks with a market value greater than $2.5 billion). You can imagine that if these funds choose to liquidate their positions in these stocks, it could have a significant impact on prices.

These 85 stocks include the seven well-known names in the following table. (Here's the full list.)

Company

% Owned by HF Managers

% Owned by Single HF Manager

October Return*

NVIDIA (NASDAQ:NVDA)

15.8%

10.1% (AllianceBernstein)

(18%)

MasterCard (NYSE:MA)

21.1%

--

(17%)

Baidu.com (NASDAQ:BIDU)

20.6%

--

(17%)

Energy Select Sector SPDR (NASDAQ:XLE)

27.5%

14.5% (CooperNeff Advisors)

(19%)

Imclone Systems (NASDAQ:IMCL)

31.1%

13.2% (Icahn Associates)

10%

Salesforce.com (NASDAQ:CRM)

16.8%

11.4% (AllianceBernstein)

(36%)

Copart (NASDAQ:CPRT)

21.6%

--

(8%)

Market-cap weighted index of top 50 stocks in terms of HF ownership

27.9%

--

(14%)

* Does not include dividends.
Source: Standard & Poor's Capital IQ and author calculations.

I constructed a market-value weighted index of the top 50 stocks in terms of hedge fund ownership (the lowest stock on the list is over 20% owned by hedge fund managers). That index lost 14% of its value during the month of October -- less than the S&P 500, which lost 16.8%. Based on that observation, I think there is reason to believe that more selling (and, hence, further price declines) could be on the way.

Non-economic selling = big opportunity for patient investors
As I noted above, Seth Klarman highlights non-economic selling in his terrific book, Margin of Safety, because it is a source of tremendous opportunity for value-oriented investors (i.e. investors who have the staying power and mind-set to make buy and sell decisions based solely on investment value). When significant market actors (such as hedge funds, for example) are no longer guided by investment value, these are the ideal conditions for the market price of equities and their intrinsic value to diverge.

That's the very definition of investment opportunity.

Even if you already own them, all is not lost
Of course, that might seem like small comfort if you already own some of the stocks on the list I compiled and you are suffering losses on these holdings. However, whether or not you already own the stock, lower prices created by selling pressure from hedge funds can create opportunity – for existing shareholders, lower prices mean you can lower your cost basis and raise your expected future returns.

(This assumes two very important things: First, you can verify that the price declines aren't warranted by the fundamentals of the business, and second, you can "double down" without breaching some reasonable boundary of portfolio diversification.)

Don't believe the hype
The financial media loves to track (and hype) what hedge funds are doing, many of them blindly supporting the notion that hedge funds -- "the smart money" -- are always one step ahead of other investors. There are a lot of smart hedge fund investors, but most face a tight set of imperatives which can, on occasion, produce sub-optimal behavior. This is one of those times and individual investors -- who don't face the same constraints -- should take advantage of it.

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Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. Baidu.com is a Motley Fool Rule Breakers pick. NVIDIA and Copart are Stock Advisor selections. The Fool owns shares of Copart. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.