Will Unexpected Hedge Fund Redemptions Hurt Your Portfolio in 2012?

The results for November are in for hedge funds and they are really bad. Looking over the list of some titans in the industry, we continue to see losing portfolios. Now, just a few weeks away from the end of the year, it appears that hedge funds will have another poor year. This might cause massive problems for the average investor in the first few months of 2012.The results for November are in for hedge funds and they are really bad. Looking over the list of some titans in the industry, we continue to see losing portfolios. Now, just a few weeks away from the end of the year, it appears that hedge funds will have another poor year, especially when relative to the S&P 500. This might cause massive problems for the average investor in the first few months of 2012.

Hedge funds are designed and created to outperform in all markets regardless of where the S&P 500 is trading. Their selling point is that they can provide positive absolute returns not relative to an index, like the S&P 500. A traditional money manager can lose five percent, but if the S&P 500 lost 10%, he can say that he “beat” the index. However, a hedge fund is supposed to make money regardless of the S&P 500.

Looking over the list of hedge funds, we can see that some giants are still underwater for 2011. Billionaire John Paulson has several hedge funds, all deep in the red. In November alone, some of his funds lost almost four percent, with four funds having year-to-date performances of -19.86%, -27.49%, -31.69% and -47.49%.

While Paulson’s performance has been particularly poor, he’s not alone. According to Bloomberg, the average hedge fund lost one percent in November and is down 3.8% for the year. Considering that an investor pays a premium to put their money into a hedge fund, versus an index that mimics the S&P 500, overall returns are dismal.

Returns have been so poor that a report by Hedge Fund Research Inc. indicates that hedge fund liquidations last quarter were the highest since the start of 2010. The report also looks at hedge funds that were completely liquidated. In the third quarter, there were 213, compared to 168 a year ago. It appears that hedge fund returns for the third quarter of 2011 were among the worst in history for the industry.

An investor can only take money out of a hedge fund after requesting the transfer a certain period of time ahead of the date, because a lot of positions are huge and are not easy to liquidate. For a lot of funds, it’s 30 days; for some, the period is longer. Unless December is a spectacular month for many hedge funds, I can imagine the question many investors will have when they receive their year-end statements: “Why are we still invested with this hedge fund versus just an index in the S&P 500?”

This will mean that many investors will decide to redeem all or at least part of their investment, to “lighten” up on some of their losing positions. If a fund receives redemptions requests at the beginning of the month, you might see sellers at the end of either January or February, to pay back funds at the beginning of the following month. If one were to look back to the January 2010 chart, you will notice a sharp sell-off for the S&P 500 at the end of the month. Perhaps not purely due to redemptions, but they certainly played a role.

This is not a recommendation to buy or sell; it’s just meant to pull back the curtain for the average investor, so you can see what really happens behind the doors of hedge funds. If we have a strong December, you might get some investors adding to their holdings. But, if the rest of the month is as bad as we’ve had all year, then we could have dramatic redemptions take place. At that point, watch the market action for the S&P 500 going into the third and fourth weeks of January. Large redemptions would be observed in the markets as sellers into every rally.