The Hedge Fund Contagion

Investors on Main Street have another reason to fear opening their brokerage statements: the rapidly shrinking hedge fund industry. In the coming months, hundreds of hedge funds may shut their doors, sparking a massive fire sale on all sorts of investments. Just about anybody with a 401(k) or pension plan will feel the pain, since the sell-off will only exacerbate the plunge in stocks, bonds, and commodities—which make up the core of most people's portfolios.

The 10,000 hedge funds with more than $1.7 trillion in assets are caught in a vicious cycle. Worried investors are pulling out their money—some $31 billion through September, according to Hedge Fund Research. As part of the great deleveraging that's happening across the financial system, lenders are cutting credit lines or demanding that funds come up with more cash in what's known as a margin call. The cash squeeze is forcing hedge funds to dump holdings. "Redemptions and margin calls are exaggerating the market swings," says Timothy M. Ghriskey, co-founder of Solaris Asset Management, a $2 billion institutional fund.

Meanwhile, the Lehman Brothers bankruptcy is tying up tens of billions of dollars of hedge fund assets. Scores of money managers parked cash and other securities at the investment bank's prime brokerage operation in accounts that are now frozen. Other hedge funds had derivative deals with Lehman, complex financial transactions that could take months to unwind.

Stay of Execution?

None of those problems will clear up any time soon. It's difficult for funds that are down 30% or more to raise new money, persuade investors to stay, or retain top talent—a fatal combination that will make it impossible for many funds to stay open in this environment. The next critical deadline: Nov. 30, the final day of the year that many hedge fund investors can file to redeem their stakes. Unlike mutual funds, which trade daily, hedge fund customers can request their money only on certain dates, typically once a month or quarter.

Clients of firms with long-term records of strong returns may decide to give the funds a stay of execution even if losses are huge. That's one reason why some hedge fund managers are pleading with their customers to stick around. Citadel Investment Group CEO Ken Griffin apologized for two funds' near-30% drop since the start of the year, promising "to create value over the years to come." Ramius Capital, down 11%, is trying to keep investors from rushing for the exits by cutting expenses, an unheard-of move in this fee-hefty business.

Despite such efforts, the wreckage is likely to be significant. Charles Biderman, chief executive of TrimTabs Investment Research, estimates that 25% of hedge funds will be out of business by the end of 2009. "When [managers] are losing money for people, [they] are not getting pleasant phone calls," says Sol Waksman, founder of industry tracking service Barclay Hedge. "Some ask, 'why am I doing this?'"

The favorite holdings of hedge funds will keep bearing the brunt of the pain from the shakeout. A Goldman Sachs (GS) index that tracks the top stocks held by hedge funds dropped by 34% over the three weeks ending Oct. 10, a period when managers were frantically selling shares. The Standard & Poor's 500-stock index, by comparison, fell by 28%. Among the biggest losers: Apple (AAPL), off 31%, and Freeport-McMoRan Copper & Gold (FCX), down 51%.

Since some hedge fund managers are selling indiscriminately, even relatively good companies can get hurt. Consider MasterCard (MA). The stock dropped 33% over that same three-week period, even though revenues were up 25% last quarter. Why is that? Hedge funds, which own roughly a quarter of the credit-card company's stock, may be putting additional pressure on the shares. One major shareholder, hedge fund Atticus Capital, has lost nearly $5 billion, or 20% of assets, since the start of the year—a steep drop that fueled speculation in September that the fund wouldn't be around much longer. Manager Timothy R. Barakett has publicly denied the rumors, insisting Atticus is in the market for the long haul.