Fund-linked hedging bolsters redemption requests

The rise in redemptions across the hedge fund industry is being exacerbated by the hedging of fund-linked options and constant proportion portfolio insurance (CPPI) products, according to dealers.

There were a record $152 billion in withdrawals from funds during the fourth quarter of 2008, according to data released today by Chicago-based Hedge Fund Research (HFR). This contributed to record net withdrawals of $155 billion during the year, leaving the industry with total assets of $1.4 trillion at year-end.

"Investor redemptions were widespread and indiscriminate across fund strategies, regions, asset sizes and performance dynamics," the firm said.

While the bulk of the outflow stems from disgruntled investors, dealers attribute part of it to hedging activity involving common fund-linked trades.

Both options and CPPIs linked to funds of funds have been popular with institutional investors over recent years. Hedging these products generally involves dealers taking stakes in the underlying funds - with dealers buying shares as the underlying fund's net asset value (NAV) rises and selling them as the fund's NAV falls.

Bankers say such forced selling activity contributed to record redemptions towards the end of 2008, as the performance of the industry took a dive.

Eric van Laer, London-based European head of fund-linked derivatives at Credit Suisse, said: "The bad performance of hedge funds has caused deleveraging across the board, both for CPPI books as well as leverage books. This has contributed to the redemption flows that have increased dramatically across the last couple of quarters."

Not all dealers have been able to redeem shares in order to hedge, however. Many funds and funds of funds have had to restrict investor outflows to protect their remaining investors, by constructing liquidity gates, suspending redemptions or creating side-pockets, for example.

Sources say this was not widely anticipated in the documentation of many fund-linked trades, resulting in nasty losses for some hedging desks. "Now banks are locked in funds of funds where they won't get a certain amount of redemption orders from the end of last year until February or March," said Laurent Le Saint, global head of sales for hedge fund-linked products at Société Générale Corporate and Investment Banking.

With some funds of funds exposed heavily to New York-based broker and fund manager Bernard Madoff, the combination of a sharp drop in NAV with a freezing of liquidity is believed to have badly charred some banks' hedging books.

Along with market volatility, Madoff's alleged $50 billion fraud has conspired to give the industry its worst full year since HFR began tracking it in 1990. The firm's HFRI Fund-Weighted Composite Index has declined 18.3% in 2008, while its Fund of Funds Composite Index is down 19.97% for the year.

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