Investors Mull How to get Out of Hedge Funds

Date: Wednesday, August 15, 2007
Author: Wall Street Journal Online

With a number of hedge funds hammered by market turmoil, the question some hedge-fund investors are now dealing with is: Should I be heading for the exit?

The subprime-mortgage turmoil and the subsequent volatility in financial markets -- including the nearly 1,000-point drop in the Dow Jones Industrial Average in the past month -- have shaken the world of hedge funds. Spooked investors in these private, lightly regulated partnerships can have difficulty knowing what to make of their investments, which are generally not as transparent as mutual funds, and which often pursue substantially more complex assets and strategies.

Hedge funds with exposure to risky home loans run by Wall Street firm Bear Stearns Cos. and Swiss banking giant UBS AG recently collapsed, rocked by market woes. And Goldman Sachs Group Inc. this week announced it was injecting $2 billion of its own money, and $1 billion from outside investors, into its Global Equity Opportunities Fund after that fund lost more than 30% of its value last week amid global-market turmoil. The Goldman vehicle, known as a "quant" fund, relies heavily on computer-driven programs to buy and sell.

Given the recent market volatility, "some investors are going to be pre-emptive -- better safe than sorry -- and give notice" of redemption, says Charles Davidson, director of the financial-services group at Standard & Poor's, which rates hedge funds and other financial institutions.

Vic Leverett, director of alternative investments at Russell Investment Group, says his firm, which manages about $31 billion in so-called funds-of-funds, or funds that invest in a basket of other hedge funds, is "getting lots of questions coming in globally about the impact of subprime and the quant strategies." But, he says, the firm hasn't yet seen large numbers of redemption requests.

One reason: Exiting from a hedge fund can be far more complex than selling a stock or a mutual fund. Redemption policies vary widely. Most funds will redeem your money only at the end of a calendar month, or the end of a quarter. And you generally must provide written notice in advance that you intend to redeem money. The notice period is often 30 days to 60 days, but some funds require as many as 90 days or more. Rules for redeeming money from a hedge fund are generally laid out in the limited-partnership agreement.

The long notice period means that investors might not see their money for weeks, or even months, in which time markets might shift dramatically. Also, fleeing your funds now won't help avoid losses already booked. And troubled funds may freeze the ability of investors to redeem their money to keep from having to dump assets at falling prices, as Bear Stearns did recently with its Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund.

For investors trying to gauge their own situation, the key challenge is knowing what your hedge fund owns. John Pernell, who runs Polaris Investment Partners, a fund-of-funds in Charleston, S.C., suggests investors start by calling the fund manager. Hedge funds typically have just a limited number of investors, often no more than a few hundred, so your chances of talking to someone that matters are pretty good.

And if a fund is being inundated with calls, it might set up a conference call aimed at explaining the current situation to all investors at once.

Investors can also review quarterly "13F" filings, in which hedge-fund managers with more than $100 million in certain public securities must disclose those holdings to the Securities and Exchange Commission. But these filings may not be useful to look inside some of the quant funds that are now stumbling, because such funds can make thousands of trades a day, says Ryan Tagal, director of hedge funds and alternative investments at Morningstar Inc.

The bottom line for investors: "If you think there's a problem at your fund, make your redemption," says Timothy W. Mungovan, co-chair of the alternative investments litigation practice at Nixon Peabody LLP.

To be sure, investors shouldn't assume their hedge fund is in trouble just because of the rash of high-profile implosions recently. The HFRI Fund Weighted Composite Index, which tracks more than 2,000 hedge funds, gained 0.49% in July and is up roughly 8% this year through July, handily beating the S&P 500 index of major stocks. Some of the best gains in July were posted by hedge funds engaged in short selling and those that focus on emerging markets and convertible bonds, according to Hedge Fund Research Inc. Short selling is an investment bet that pays off if shares decline.

Still, some of the market's sharpest moves didn't occur until August, and the hedge funds facing the most trouble, while relatively few, could have a dramatic impact on the total sector's results once new numbers are released.

Tom Whelan, chief executive officer at Greenwich Alternative Investments LLC, a hedge-fund advisory and asset-management firm, estimates that "maybe 10% to 15% of funds are feeling what's going on, to various degrees." Overall, the industry comprises roughly 6,000 to 8,000 U.S. hedge funds that manage about $1.5 trillion in assets.

Still, investor nervousness goes beyond the hardest-hit funds that invest in subprime mortgages and make use of quantitative trading strategies. Bob Gordon, president of Twenty-First Securities Corp., a broker-dealer advising high-net-worth individuals, says one of his clients called recently seeking to redeem money from a municipal-bond arbitrage hedge fund, which Mr. Gordon says has been "doing well." The client "is really nervous," Mr. Gordon says, "because of all that has been going on in the last week or so."

Investors who successfully withdraw money from a struggling hedge fund may still be at risk. If a hedge fund fails, in some cases a bankruptcy trustee or other investors may sue investors who have already redeemed money and try to force them to pay that money back into the fund, say Nixon Peabody's Mr. Mungovan and his co-chair of the firm's alternative investments litigation practice, Jonathan Sablone.

The trustee could argue that the hedge fund didn't value its assets correctly and that investors withdrew more money than they were entitled to, the lawyers say. This concept "may well apply to some of the fund failures we're seeing right now," because some funds involved with, say, subprime-mortgage-related securities may have a hard time valuing their assets and could wind up in bankruptcy, Mr. Mungovan says. It's "the Hotel California" syndrome, he says. "You can check out anytime you like, but you can never leave."

Investors need to read hedge-fund offering documents and limited-partnership agreements carefully to understand redemption rules. In some cases, funds may impose a penalty on investors who try to withdraw money without giving proper notice or require longer redemption notice periods for investors who want to take out money at year end, says Ferenc Sanderson, senior research analyst at Lipper Inc.

In some cases, investors have negotiated in advance special agreements with hedge-fund managers known as a "side letter," which may allow the investor to redeem money more quickly than other investors in the fund. Often, however, such agreements are reserved for very large investors like institutions.

And some funds will on occasion waive the redemption period, effectively allowing antsy investors to exit early. But Mr. Gordon, the broker-dealer, says funds might be less likely to do that now. "I'm not sure now is a normal circumstance," he says.

Write to Jeff D. Opdyke at jeff.opdyke@wsj.com and Eleanor Laise at eleanor.laise@wsj.com