Keith Fitz-Gerald

Four Ways to Sidestep the Street's Big Money Bulldozer

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Did You Hear That?

My experience suggests that one or more hedge funds have imploded. Whether by margin call or redemption proceedings is a moot point. We won't know for sure until much later next week when the newspapers finally catch up, but the massive swings we saw in currencies, gold and other commodities are certainly consistent with an unprecedented liquidation -- and a forced one at that. Perhaps even more than one.

Long the domain of hedge funds and their uber-rich clientele, many hedge funds were overweighted in these categories in recent months in an attempt to chase performance.

"Overweighting," in case you're not familiar with the term, means they've made excess investments in those areas. And "chasing performance" means they're trying to create higher returns by making disproportionately larger bets than they would otherwise.

Part of this could be from simply trying to generate larger performance fees, but it could just as easily be attributed to anxious managers placing ever-larger bets in an attempt to make up losses (most hedge funds are under water this year).

How Trouble Finds Hedge Funds

Where this gets fund managers in trouble is when they make these overweighted bets by using leverage. You've probably heard this term a lot lately. In case you don't understand what it really means, let me explain it. Leveraging up (or simply "levering" to those in the industry) means using borrowed money to control a huge pile of assets that you wouldn't otherwise be able to control.

In recent years, for instance, it wasn't unusual for a hedge fund to lever up 30-to-1, meaning for every $1 dollar they invested, they borrowed $29. As a result, a fund with $10 million under management could control $300 million or more of investable assets. I've heard of some funds running 50-to-1, while currency traders routinely run 100-to-1.

While using other people's money dramatically enhances the potential for higher returns, it really enhances the potential for massive losses. Where this gets them into trouble is that a fund running 30-to-1 only has to lose 3% of the $30 worth of equity to get wiped out, as in kaput.

Somewhere along the way, as bad turns to worse and performance deteriorates, a hedge fund's creditors will place a margin call, meaning they want the hedge fund to pony up more collateral or return the money it was loaned. Or, investors will place redemption requests, meaning they want out. Either way, this forces the operator of a hedge fund to raise money any way it can.

If a given hedge fund does not have enough cash to meet the margin calls or redemption requests, they have to raise cash by selling assets. And they typically start with the most liquid stuff like gold, currencies and commodities. At first, the sales progression will be orderly, but as I suspect was the case last Friday (and on many big down days recently where chaos ruled), it will rapidly deteriorate into a fire sale where the hedge funds involved dump everything they can at any price just to get out.

And that's where their problems affect you and me.