Will Hedge Fund Investors Panic Next?

Date: Thursday, August 26, 2010
Author: Andrew Bond, The Motley Fool

As individual investors, we don't necessarily need to worry about what mutual fund, hedge fund, and institutional managers are doing with the money they have under management. Instead, we seek out high-quality companies, with strong businesses and management teams, and reward those companies with our faith and investment dollars. However, as retail investors continue to withdraw money from mutual funds at a record pace, it can be useful to know which stocks these funds are holding and therefore may need to sell if fund shareholders demand their capital back.

Mutual funds flow out
Unlike smaller individual investors, institutional funds have the ability to move share prices when they buy or sell. Many mutual funds have mandates to be almost fully invested in the markets at all times. Investors allocate their capital to these fund managers because they believe that said managers will deliver superior returns. So as more money goes into funds these managers are required to buy more shares, and when money flows out they must sell to redeem their investor's capital.

This past week marked the 15th in a row in which money flowed out of U.S. stock mutual funds, a new record, according to the Investment Company Institute. So far in August, investors have withdrawn more than $4.1 billion from mutual funds. In July, even as the stock market jumped by more than 7%, investors pulled out $14.67 billion. This is particularly troubling because retail investors tend to invest more money when are markets go up and sell when they go down. However, it appears that investors are selling on both up-moves and dips as fears of another flash crash or 2008 style meltdown persist.

Hedge funds flow slower ... for now
Hedge funds, on the other hand, are a different animal entirely. Most individual investors aren't allowed to invest their own money with these institutions, as they require a much greater amount of capital from investors in order to participate in these more private funds.

Just as difficult as it is to invest in a hedge fund, it can be even harder for those invested to get their money out. Hedge funds have much stricter rules on when investors can redeem their capital and how much they are able to redeem at a certain time. Many hedge funds invest in illiquid or thinly traded investments, which make it difficult to return all invested capital to investors without advance notice.

Some of these restrictions may explain why, unlike its mutual fund counterparts, the hedge fund industry has seen inflows of investor capital throughout most the year and added $9.3 billion in new investment in July, reversing an outflow of funds in June.

Could these stocks get hurt?
Some hedge funds beefed up their withdrawal restrictions during the stock market collapse in 2008, as investors of all asset classes tried frantically to get out of the market. When hedge fund investors begin to panic, managers must prepare for withdrawal by selling assets. As hedge funds begin to sell off assets in order to return capital to investors, they typically start with their most liquid assets, which are almost always stocks. With global equity markets in turmoil and volatility increasing across the board, knowing which stocks these funds favor can give you an edge.

Goldman Sachs recently released its quarterly hedge fund monitor, which lists its hedge "VIP" (Very Important Positions) list that ranks the most owned stocks by domestic hedge fund managers. The most often held company is Apple (Nasdaq: AAPL), with a reported 75 hedge funds including it as a top 10 holding as of June 30. JPMorgan Chase (NYSE: JPM) and Pfizer (NYSE: PFE) also have followings of 35 funds or more.

But while hedge funds in aggregate own only about 4% of Apple's stock, they hold much larger positions of 35% in CIT Group (NYSE: CIT), 23% in Fidelity National Information Services (NYSE: FIS), and 36% of Lear Corp. (NYSE: LEA).

While members of this "VIP" list are obviously thought of highly by the hedge fund community, these stocks could also see additional selling pressure should the market plunge continue and redemptions increase. Be mindful of stocks like these that are heavily owned by institutions, as they can fall just as fast, if not faster then they went up.