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2.7%  Q1 GDP    4.57%  avg. 30-year mortgage     9.5%  Unemployment

Are Hedge Funds Next to Fall?

Most Americans don't invest in hedge funds. But their demise is another sign of a worsening economy.

Years ago, hedge funds were set up to guard -- or hedge -- against risk. Today, they usually are high-risk, high-return businesses--hedges in name only.

Hedge funds are usually private, open to a limited number of select investors who put a lot of money in for an extended period of time, such as a year. Because they are private and cater to sophisticated investors, they are typically unregulated.

In boom times, hedge funds boom, generating high returns for their investors.

But in bust times, like now, they go down too.

According to TrimTabs Investment Research preliminary data released this morning, investors pulled $43 billion out of hedge funds in September, the largest one-month withdrawal in history. October could show an even bigger cash pullout, TrimTabs says.

Why?

Because the hedge funds have performed just as poorly as the rest of the markets. Plus, they're usually riskier. So investors want their cash out.

Like many big institutions, hedge funds often wait until the last hour of trading to buy or sell shares. When the market already is going down, dumping a big chunk of shares in the last hour acts like an accelerant on a fire.

We got a question from a reader on our posting on last-minute trading from yesterday asking why big institutions wait until the last hour to dump or buy shares. So we turned to our go-to guys at Alexandria's Motley Fool for the answer. Fool adviser Bill Mann gave us the answer, which we've condensed and edited for this posting:

"Lots of funds are doing something called 'hedging variance.' This means that they want to hedge away the the risk of a price move by buying and [short-selling] the same security. They do this all the time, but usually we don't notice.

But now fear levels are so high that traders are reluctant to even consider buying into the close. How many nights and weekends over the last two months have we had something huge happen? Hedge funds don't want exposure to [outside] events while they cannot trade. What happens then is that most of the volume at the end of the day is going short (or selling) to limit this risk."

Mann writes that things really heat up in the last 20 minutes of trading:

"There is actually a process for this, called 'Market on Close.' At 3:40 p.m. [20 minutes before the markets close] every trading day orders are posted to indicate whether there are unusual levels of buy or sell orders for individual securities at the close. They do this to let market participants know about any imbalances. This is revised at 3:50 p.m.

Usually these have little impact. But these days, the Market On Close orders are kind of like a cannon going off and they signal to other investors that there's market trouble coming. When the Market On Close sell orders are high, they've run to the exits.

Few will actually admit this -- but that's what happens in the last 20 minutes."

-----

Here's a quick look at other economic news that has rolled out so far today:

-The Swiss National Bank and the Fed have agreed to buy $60 billion in toxic assets from UBS.

- The cost of living in the U.S. -- judged by the Consumer Price Index -- remained unchanged in September.

- Financial giant Citigroup posted its fourth-straight quarterly loss and will cut 11,000 jobs.

- Industrial production in the U.S. hit a 34-year low in September, thanks to a combo punch from a couple of hurricanes and the ongoing machinists' strike at Boeing.

- New jobless claims from last week jumped higher than expected.

-- Frank Ahrens

By Frank Ahrens  |  October 16, 2008; 2:25 PM ET
Categories:  The Ticker  
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