Stocks, bonds, and commodities will suffer as funds dump assets. Anyone with a 401(k) will get hit

Investors on Main Street have another reason to fear opening their brokerage statements: the rapidly shrinking hedge fund industry. In the coming months, hundreds of hedge funds may shut their doors, sparking a massive fire sale on all sorts of investments. Just about anybody with a 401(k) or pension plan will feel the pain, since the sell-off will only exacerbate the plunge in stocks, bonds, and commodities—which make up the core of most people’s portfolios.

The 10,000 hedge funds with more than $1.7 trillion in assets are caught in a vicious cycle. Worried investors are pulling out their money—some $31 billion through September, according to Hedge Fund Research. As part of the great deleveraging that’s happening across the financial system, lenders are cutting credit lines or demanding that funds come up with more cash in what’s known as a margin call. The cash squeeze is forcing hedge funds to dump holdings. Redemptions and margin calls are exaggerating the market swings, says Timothy M. Ghriskey, co-founder of Solaris Asset Management, a $2 billion institutional fund.

Meanwhile, the Lehman Brothers bankruptcy is tying up tens of billions of dollars of hedge fund assets. Scores of money managers parked cash and other securities at the investment bank’s prime brokerage operation in accounts that are now frozen. Other hedge funds had derivative deals with Lehman, complex financial transactions that could take months to unwind.

Stay of Execution?

None of those problems will clear up any time soon. It’s difficult for funds that are down 30% or more to raise new money, persuade investors to stay, or retain top talent—a fatal combination that will make it impossible for many funds to stay open in this environment. The next critical deadline: Nov. 30, the final day of the year that many hedge fund investors can file to redeem their stakes. Unlike mutual funds, which trade daily, hedge fund customers can request their money only on certain dates, typically once a month or quarter.

Clients of firms with long-term records of strong returns may decide to give the funds a stay of execution even if losses are huge. That’s one reason why some hedge fund managers are pleading with their customers to stick around. Citadel Investment Group CEO Ken Griffin apologized for two funds’ near-30% drop since the start of the year, promising to create value over the years to come. Ramius Capital, down 11%, is trying to keep investors from rushing for the exits by cutting expenses, an unheard-of move in this fee-hefty business.

Despite such efforts, the wreckage is likely to be significant. Charles Biderman, chief executive of TrimTabs Investment Research, estimates that 25% of hedge funds will be out of business by the end of 2009. When [managers] are losing money for people, [they] are not getting pleasant phone calls, says Sol Waksman, founder of industry tracking service Barclay Hedge. Some ask, ‘why am I doing this?’

The favorite holdings of hedge funds will keep bearing the brunt of the pain from the shakeout. A Goldman Sachs (GS) index that tracks the top stocks held by hedge funds dropped by 34% over the three weeks ending Oct. 10, a period when managers were frantically selling shares. The Standard & Poor’s 500-stock index, by comparison, fell by 28%. Among the biggest losers: Apple (AAPL), off 31%, and Freeport-McMoRan Copper & Gold (FCX), down 51%.

Since some hedge fund managers are selling indiscriminately, even relatively good companies can get hurt. Consider MasterCard (MA). The stock dropped 33% over that same three-week period, even though revenues were up 25% last quarter. Why is that? Hedge funds, which own roughly a quarter of the credit-card company’s stock, may be putting additional pressure on the shares. One major shareholder, hedge fund Atticus Capital, has lost nearly $5 billion, or 20% of assets, since the start of the year—a steep drop that fueled speculation in September that the fund wouldn’t be around much longer. Manager Timothy R. Barakett has publicly denied the rumors, insisting Atticus is in the market for the long haul.

Hedge funds aren’t just dumping stocks. In early September, Ospraie Management, one of the largest players in the commodities market, had to shutter its flagship fund after it lost nearly 27% from wayward bets on oil, natural gas, and the like. Winding down the fund and selling off the assets—at one time worth $3.8 billion—have contributed to the precipitous decline in commodity prices since the summer. On Oct. 20 an executive at mining conglomerate Rio Tinto (RTP) blamed hedge fund liquidations for unduly punishing uranium prices.

No corner of the market has been spared. After Lehman filed for bankruptcy on Sept. 15, the investment bank’s traders dumped tens of billions of dollars of convertible bonds—hybrid securities that have both equity and debt features. Flooded with investments, the market for convertible bonds tanked.

Leveraged Loans

The weak prices prompted lenders to ask managers who owned such securities to pony up more cash in margin calls. Unable to do so, some funds trashed holdings. One convertible bond fund caught in the crossfire: the once $6 billion Platinum Grove Asset Management, founded by Nobel prizewinning economist Myron S. Scholes. Sources familiar with Platinum Grove say its portfolio has suffered deep losses this year.

Perhaps nowhere has rapid-fire selling been more pronounced than in the $500 billion market for so-called leveraged loans. In recent years companies sold these securities to finance private equity buyouts, acquisitions, and other corporate deals. But hedge funds, which lined up to buy the loans during the boom, have been off-loading them in recent weeks to meet redemptions and margin calls.

Highland Capital Management, a $38 billion money-management shop that invested heavily in this arena, has been among the most aggressive sellers of leveraged loans. Highland declined to comment.

The sell-off by hedge funds and other investors is depressing loan prices. In recent weeks the value of the typical loan, according to research firm Standard & Poor’s LCD, quickly dropped from 85¢ on the dollar to just 66¢, a deeply distressed price usually reserved for companies that are in bankruptcy. (Historically, investors have recovered 70¢ on the dollar when a company defaults.)

Yet few of the companies whose loans are trading near those prices, including utility TXU Energy and credit-card processor First Data, are in such dire straits. The loan market is a very funny place right now, says David Ford, a founding member of Latigo Partners, a hedge fund that buys distressed investments. It’s not being driven by fundamental forces.

In essence, the market is suggesting that owners of such securities won’t get their money back. That unlikely scenario has some market observers scratching their heads. In the event of bankruptcy, investors in leveraged loans are the first to be repaid, outranking other holders of corporate debt and stock. And many companies today have more than enough assets on hand to make their loan investors whole. For example, Tennessee-based Community Health Systems (CYH), whose loans are selling for roughly 75¢ on the dollar, has $9 billion in assets, far more than its $6 billion in loans.

Although fear still dominates the loan market, there are small signs of hope. Prices are so cheap that investors potentially can make nice returns even without borrowing to do so. Rizwan Hussain, a credit strategist at Morgan Stanley (MS), pointed to the bargains in a report to clients on Oct. 17. Since then, Hussain has been fielding calls from institutional investors about opportunities. And, he says, some of those money managers don’t have to worry about meeting redemptions and can put their money to work right away—assuming they’re willing to risk the market dropping further. In the short run, it’s easy to get run over, says Latigo Partners’ Ford.

Those corporate credit markets are a crucial signal. They must bounce back before the stock market has a chance to fully recover. After all, until investors are confident that companies can cover their debts, it’s hard to have faith that their stocks will stabilize, much less appreciate.

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Shakeout Ahead

Nouriel Roubini, whose gloomy predictions about the financial crisis have proved all too accurate, thinks there will be a run on thousands of highly leveraged hedge funds: After a brief lockup period, investors…can redeem their investments on a quarterly basis, [making] a bank-like run on hedge funds highly possible, the New York University economist writes on his Web site. He says the bloated industry will suffer failures over the next two years as investors pull their money and banks pull credit lines.

bx.businessweek.com/hedge-funds/reference.