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A hedge fund's balancing act Add to ...

When markets tank, many investors want to take their chips off the table. But for some hedge fund investors that might not be an option. Not because of heightened fortitude, but because the fund won't allow it.

Not all hedge funds are created equal as many are conservatively managed. But we tend to hear more about the high-flying and hard-crashing ones. These tend to come with provisions in their offering memoranda that are actually designed to protect the investor, but when enacted, usually draw their ire.

Lock-Up Periods

Whereas a mutual fund can process redemption requests daily, some hedge funds may only process redemptions monthly, quarterly, and in some cases only annually (or longer). These are known as lock-up periods. The reason they might exist is that some hedge funds invest in less liquid investments. These underlying investments themselves may not be able to be sold by the hedge fund for extended periods of time so they cannot generate the cash to fund the redemption request.

Redemption Notice Periods

For the same reason, redemption requests may be required to be given months before a redemption date. So if you wanted your money in the first quarter of 2012, you may have had to place your redemption request in the summer of 2011. The lock-up periods and redemption-notice periods allow a manager to exit a strategy with some flexibility as to the timing of the underlying investment sale. Illiquid investments can be tough to sell on short notice, which means a fire-sale price might have to be taken. That would translate into lower returns for hedge fund unit holders.

Gating and Redemption Suspension

If your hedge fund has these provisions in the offering memorandum, the fund has the right to restrict the total amount of redemptions partially (gating) or completely (redemption suspension) if it feels it is in the best interest of the unit price. If there were a lot of investors looking to get out of the markets at the same time, the manager would otherwise be forced to sell potentially illiquid investments at a fraction of their perceived intrinsic values. In some cases they may not be able to sell the investments timely, and not be capable of funding the redemption requests at all.

So while these provisions are designed to protect the investor, people who receive a letter from their hedge fund manager informing them of a gating or a redemption suspension are rarely appreciative. We know that when markets crash, some people want out. Unfortunately, the times when these provisions are most likely to be enacted are precisely when investors want their money the most.

Preet Banerjee, BSc, FMA, DMS, FCSI is a W Network Money Expert, and blogs at wheredoesallmymoneygo.com . You can also follow him on twitter at @PreetBanerjee

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