Mystery behind hedge fund redemptions

The increase in microcap hedge funds over the last 15 years has been sizable. The six-figure, or larger, minimum investment for many of these funds would naturally include wealthier investors who can take a longer-term approach. We know that in the past many hedge fund managers have regularly been in contact with their investors by phone, e-mail or in person. We recently thought it would be interesting to see what some of these “well heeled” microcap investors were saying, so we called one of our former clients who is a very smart and successful small cap hedge fund manager in New York City. We asked the fund manager what are the people pulling money out of your fund (redeemers) saying?

The answer we got from our former client about share redeemers was interesting. We had initially thought he would talk about anxiety in the market, alternative investments, market cap size or cash. But the answer we got was that he had heard nothing. You see there is now a new fund investor out there that you don’t know and can’t talk to – the fund of funds. Let’s take a look at this new investor that cannot be talked out of redemption.

A fund of hedge funds is a fund of funds that takes money from investors and invests it in a portfolio of different hedge funds rather than individual securities. The idea is to provide broad exposure to the hedge fund industry and to diversify the risks associated with an individual fund (or fund manager). Funds of funds create a “portfolio” of hedge fund managers based on performance and/or other criteria such as specific sectors or risk considerations. The fund of hedge funds hires and fires investment advisors for their underlying clients. Funds of hedge funds generally charge a fee for their services. In addition to the hedge fund’s management fee of typically 1.5%, there can be a performance fee of 15-20%, or more. While funds of funds can be an easy way to diversify for many large investors, they have been criticized for the significant incremental costs they impose. Many funds of funds have been known to be quicker to change managers as the sponsor just blames an underlying manager for any lack of performance.

So, what did our former client say to his investors who were redeeming? Nothing, because all he had was a redemption notice, he never knew whose money he had managed. It is our view that this creates even more volatility as the portfolio manager cannot give his advice or investment rationale to the client. So, there is one more thing different about this market: a lot of anonymous high net worth or institutional investors.