Hedge funds have been getting crushed, and it is hurting everyone else in the market

Hedge funds are having a tough time, and making life much harder for everyone else in the market.

The industry’s poor performance lately has investors pulling money out of the funds.

That has led to a dropoff in bond market liquidity, as funds which might have snapped up bonds as their prices fell, instead steer clear, says Mark Heppenstall, chief investment officer of Penn Mutual Asset Management.

“Hedge funds were a backstop for the markets and helped provide that liquidity,” said Heppenstall, who oversees over $20 billion in assets managing the investment arm of Penn Mutual Insurance. “So when they started to underperform for a while and started to shift into risk off, it eliminated that.”

That shift has made life harder for everyone.

“Liquidity is the main source of the extreme downward and upward moves in the market right now,” he said in an interview with Business Insider.

The original problem

Liquidity, in the most basic sense, is the idea that sellers can find buyers easily and vice versa. So when liquidity “dries up” the sellers have to drop their asking price in order to find someone willing to take on the asset.

The consensus on Wall Street is that this liquidity is deteriorating. Executives from JP Morgan’s Jamie Dimon to Blackstone’s Steve Schwarzman have brought up this concern.

Typically, prior to the 2008 crisis, there were two buyers of last resort: banks and hedge funds. Due to regulatory requirements, big banks no longer have that capacity.

“The ability of [Wall] Street to cushion the flows just isn’t there anymore,” said Heppenstall. “They aren’t in a place where they can absorb any of the selling or volatility.”

That puts the onus on hedge funds to be the backstop buyer in the post-recession world. Funds as a whole have begun to struggle, however. Hedge funds are down 3.8% so far in 2016, driving up the rate of redemptions from investors.

Mark Heppenstall

According to data from eVestment, around $21.5 billion was returned to investors from hedge funds in January, the most to start the year since 2009. In order to prepare themselves from these redemptions, and to try and improve performance, hedge funds have been moving out of riskier assets.

“I just think hedge funds are clearing the decks of riskier assets right now, and my feel is that they’re pretty well through the process,” said Heppenstall.

This trend has also been exacerbated by the closing of large funds. Heppenstall referenced the closure of Third Avenue Management, and its junk bond-focused fund that collapsed in mid-December, as a reason some other funds have moved to safer ground.

This nervousness over closures also makes sense. The Federal Reserve Bank of New York found in a recent study that the risk of a “firesale” of redemptions spreading among funds and impacting financial markets is at its highest in a decade.

“The fact that some large funds, such as Third Avenue, were facing redemptions, that changed the appetite for all funds in terms of risk,” he told us.

All this adds up to a rougher environment for investors like Heppenstall.

“While I’m expecting some near-term calmness over the next month or two, this sort of volatility and liquidity risk is not going away,” he said.

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