The Hedge-Fund Exodus Trickles Down

Big-money investors in hedge funds are fleeing the market just like the small guys. And as they demand their money back, hedge-fund managers are having to raise cash to meet the redemptions. It might seem like an offstage drama that shouldn't concern the rest of us, who don't play in that rarefied world. But hedge funds do gobble up large swaths of the stock market, and their sales of shares can strongly affect shares that many other, smaller investors also own.

Case in point: small- and mid-cap stocks. Hedge funds built up large positions in these shares and were partly responsible for their strong performance in recent years, according to Lori E. Calvasina, an analyst with Citi Investment Research. In the second quarter, for instance, hedge funds had an average stake of 15.5 percent in small and mid-cap telecoms and an average 13.6 percent stake in small and mid-cap materials companies. (Those businesses involved in raw materials such as mining, chemical production and forestry products.) Those sectors turned in among the worst returns in the small- and mid-cap universe in September, Calvasina said in a report last week. Phosphates producer Innophos plunged 35 percent during the month.

"Hedge fund moves into cash may have had something to do with dismal September returns in these sectors," Calvasina wrote.

Such continuing moves by hedge funds could put further pressure on small- and mid-cap stocks in a variety of sectors, she warned. That's because the hedge funds have deep positions in sectors that have overall a fairly small market capitalization, so the moves can have an outsize impact.

Average investor beware: the behemoths' need for cash could stomp on your holdings of small- and mid-cap stocks. "This dynamic could keep markets under pressure," Calvasina said. But she also held out a silver lining: "Ultimately the cash on the sidelines may become a source of buying power if redemptions are less than feared."

-- Steven E. Levingston