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Copycat Selling Maroons Investors as Hedge Funds Cash In

By Liz Peek - Updated Apr 5, 2017 at 8:01PM

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There were more than 8,000 hedge funds operating at the start of 2008. How many will survive?

What does the turmoil in the hedge fund world mean to most investors? Losses and more losses. Over the past few weeks, the forced deleveraging of the industry, combined with redemptions by frantic clients, has led to hundreds of billions in stock sales (redemptions in the third quarter amounted to $117.3 billion, according to a new report out by HedgeFund.Net), creating horrific declines in many stocks -- but interestingly, not in all stocks.

According to an equity strategist for one of the most successful fund-of-funds outfits in the country, stock holdings among equity hedge fund managers are and have been highly concentrated. Described as "crowded longs," these most-favored stocks tanked in September and October as funds scrambled for cash. Overall, equity long-short funds are down 25% year to date, according to Hedge Fund Research, compared with a near-40% slide in the S&P 500. While hedge funds have outperformed, the showing certainly is disappointing for an industry that is supposedly hedged. The shortfall is because so many managers own the same stocks, and all rushed to sell at the same time. (There were more than 8,000 hedge funds operating at the start of 2008.)

So many mirrors
The reason for the concentrated holdings, I am told, is that hundreds of managers comb through the quarterly 13-F filings of the best-of-breed funds with the Securities and Exchange Commission and duplicate their portfolios. In other words, they look up what Steve Cohen bought last quarter for SAC Capital, or what Steve Mandel bought at Lone Pine Capital, and they buy the same names. No wonder a huge bunch of hedge funds may go under!  

There are reporters from outfits like Seeking Alpha who help out the wannabes by poring through the 13-F filings and publishing the changes in portfolios. A quick glance at some of the reports shows, for instance, that Google (NASDAQ:GOOG) was a top pick for big-name players such as Tremblant, Clarium, and others in the third quarter, while Visa (NYSE:V), Qualcomm (NASDAQ:QCOM), and Sears (NASDAQ:SHLD) were also purchased by top funds.

Goldman Sachs publishes what it calls the Hedge Fund VIP List, which includes the stocks most widely held by the biggest funds. Changes in the index -- like when Petrobras (NYSE:PBR) and PotashCorp (NYSE:POT) were added to the list at the end of August -- rate major media coverage. The index, according to Bloomberg, is down 43% year to date, compared with a 38% drop in the S&P 500. While it outperformed the S&P early this year, it sank below the market overall in October and November.

OK, so it's one thing for you and me to play copycat investing. But a hedge fund manager who's being paid 2 and 20? (A management fee of 2% annually and a performance fee of 20% on gains is the industry norm.) The strategist I spoke to said that his firm has actually had managers come in to pitch their fund, citing this follow-the-leader approach as their strategy. Needless to say they were not invited into the fund of funds.

The cash grab
Because so few firms will be judged to have actually added value during this period, the hedge fund world is undoubtedly due for some serious restructuring. Thousands of firms may close their doors. Even the funds that have outperformed are bleeding; investors are looking for cash wherever they can find it. Institutions like pension plans and endowments are suddenly facing capital calls on private equity investments made in recent years and are cashing in their hedge funds to come up with the money. Not all, however, will get their money out.

With so many investors rushing simultaneously for the exits, many hedge funds have activated their so-called gates, which limit how much a single investor can withdraw from a fund at any time. Erecting gates was one of a number of advantages that hedge fund companies added as returns soared in the past several years. As a tsunami of money washed into the industry, funds were in a position to not only raise fees (the very top of the pile began to charge as much as 3 and 30) but also to institute longer lockups and gates, limiting clients' access to their funds.

Though the percentage of hedge funds with gates may be small, navigating the opening and closing process is one of the greatest challenges for those running funds of funds today, who may themselves be facing redemptions. The restrictions normally cap the amount of money an investor can redeem to between 15% and 25% of his or her total holdings.

In the past, if a hedge fund enforced a gate, that could have put it out of business -- because it would suggest mortal weakness. These days, the practice is more widespread, and it is the funds of funds that are in jeopardy if they cannot come up with investors' money.

As we emerge from this cataclysmic year, the investment landscape will look quite different. There will, for sure, be fewer hedge funds, and the survivors will be those that actually bring value. They may, in fact, have to earn their 2 and 20.

Fool contributor Liz Peek owns shares of Google. Petroleo Brasileiro is a Motley Fool Income Investor selection. Sears Holdings is an Inside Value pick. Google is a Rule Breakers recommendation. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool is investors writing for investors.

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Stocks Mentioned

Alphabet Inc. Stock Quote
Alphabet Inc.
GOOGL
$117.30 (-0.14%) $0.17
Sears Holdings Corporation Stock Quote
Sears Holdings Corporation
SHLDQ
Visa Inc. Stock Quote
Visa Inc.
V
$213.32 (-1.18%) $-2.55
QUALCOMM Incorporated Stock Quote
QUALCOMM Incorporated
QCOM
$147.81 (-1.60%) $-2.40
Nutrien Stock Quote
Nutrien
POT
Petroleo Brasileiro S.A. - Petrobras Stock Quote
Petroleo Brasileiro S.A. - Petrobras
PBR
$15.34 (6.16%) $0.89

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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