By Philip Elmer-DeWitt
November 3, 2008

There’s an interesting and timely paragraph about Apple buried in the middle of Scott (“The Finance Professor”) Rothbort’s latest primer on hedge funds (Hedge Fund Liquidations: Five Things You Need to Know).

He’s explaining how hedge fund investors — technically, limited partners — are only allowed to withdraw money on an quarterly or annual basis, which can result, when a fund is performing poorly, in a rush of redemptions that resembles a run on a bank.

To meet those redemption requests, a hedge fund leveraged 5 to 1 will have to sell at least $5 of investments to meet every $1 of redemptions. (And 5 to 1 is conservative; a hedge fund can, in theory, be almost infinitely leveraged.)

This is where Apple comes into Rothbort’s primer:

“As redemptions tend to be clustered, the impact on individual stocks from hedge funds liquidating their holdings (to meet those redemptions) will be a magnified and concentrated hit on those stocks, and potentially the overall market.

“Since the hedge funds are more concerned about creating liquidity than preserving the integrity of their portfolios during a crisis, the higher priced stocks tend to get sold first. It is far easier to create $10,000,000 of cash by selling smaller amounts of a $200 stock (say Apple AAPL than larger amounts of a $25 stock (say Altria MO ). And before you know it, that $200 stock has become a $100 stock. ‘Classic’ valuation is thrown out the window.”(link)

Investors pulled a record $43 billion out of U.S. hedge funds in September, according to the
Financial Times
, a month in which Apple fell more than 60 points (36%), from $166 a share to $105.

What makes this timely?

Another run on the hedge funds could be just around the corner. Some experts anticipate a flood of redemption requests around Nov. 15, the notification deadline for investors who want to get their money out before the end of the year. (Most hedge funds insist that investors notify them of their intentions 45 to 65 days before the end of a quarter; see here. Last quarter’s notification day was Aug. 15, and Apple got hammered from mid-August to early October.)

Apple investors, fasten your seatbelts. You could be in for a bumpy ride.

[Thanks to “cramar” at TMO’s Apple Finance Board for the tip.]

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