Investors who think they can speedily exit from hedge funds if there is no explicit lockup term in a contract may still find that redemptions can be halted.

Hedge funds have suffered a torrid year but investors who think they can speedily hit the exits from the $2 trillion sector if their funds do not have lockup clauses may still struggle to withdraw in a hurry.

The problem for worried investors is that fund firms, even if they do not have an explicit lockup contract, can still reserve the right to halt or cap redemptions in times of stress. This can wrongfoot unwary investors where a fund  normally has relatively generous liquidity terms, such as 30-day notice periods, for example. Yet it is precisely at times of market turmoil that investors most want to get out, John Godden, managing partner of IGS, a London-based consultancy firm for investors in alternative assets, told WealthBriefing.

He points to the case of

US hedge fund firm Ospraie Management, which last week said it planned to shut its flagship fund after it fell sharply in August, as an example of how redemptions can be suddenly imposed. “Ospraie haven’t got significant lockups in their main funds but have used the small print in their prospectuses to suspend redemptions. There is hardly a prospectus of any fund out there that does not give a fund the right to do this at some stage,” Mr Godden said.

There are other examples: the US Hedge fund Ore Hill Partners, which specialises in credit strategies, has barred clients from redeeming their money from its flagship offering, imposing a freeze just as investors clamoured for an exit. It put up what is called a gate provision on its Ore International fund, limiting the amount that clients can pull out.

Standard & Poor’s recently told WealthBriefing that while redemption suspensions were hardly a novelty, there has been more scrutiny of liquidity terms of hedge funds in recent months as the industry has come under stress.

The redemption issue is typically far more important for investors in a single fund rather than those who access the sector through a diversified fund-of-funds structure, since in the latter case, the intermediaries should do the due diligence checks on liquidity terms anyway, said Randal Goldsmith, director of the S&P fund services team in London.

“The current environment is definitely one where you have to mind your eye,” he said.

Penalties for speedy withdrawals are hardly confined to the hedge fund industry, however. Even in the mass market for

UK unit trusts, for example, providers can and do try to curb heavy withdrawals by reducing the potential price an investor can get for selling up, as happened when a number of UK property unit trusts were hit by large exits. The reason for curbs, firms say, is to protect remaining investors in a fund.

And the need for redemption penalties or even explicit lockups makes great sense, investors say, in hedge funds which play in illiquid sectors such as merger arbitrage and sectors involving long-term plays, such as activist funds. In any event, one way investors can quickly sell out of a fund is to hold a listed hedge fund or fund of funds, and sell the shares. However, in these cases investors may suffer a loss if the fund trades at a discount to its net asset value at the time the shares are sold.

Jonathan Bell, chief investment officer at Stanhope Capital, the UK multi-family office, said his firm looks closely at the relative liquidity – or ability to withdraw funds quickly – when scrutising a client’s portfolio.

“People can go into a hedge fund with 30-day liquidity and think that they will be able to get out fairly quickly. In a crisis, however, many funds are able to halt or delay redemptions,” Mr Bell said.

“Normally, when hedge funds close down they delay redemptions in order to manage the fund to maximise its value and investors may wait for a year to receive their money back,” he added.

Recent markets have not been kind to hedge funds, although the sector as a whole has not fared as poorly as stock markets on average.  According to Hedge Fund Research, the Chicago-based firm tracking the sector, its HFRX snapshot of average hedge fund performance shows a loss of 5.8 per cent in the year to 3 September 2008. However, while disappointing, this is not as severe as the 15.7 per cent drop in the MSCI World Index of developed countries’ equities since January.

When investors get nervous, it is hardly surprising that hedge funds will want to defend themselves if possible by invoking contract terms, said David Miller, head of alternative investments at Cheviot Asset Management, the

UK wealth management house.

“When you invest in a single-manager hedge fund you should be an expert investor or be advised by a professional. Individual hedge funds can experience problems for a variety of reasons and if they are unable to liquidate positions to meet investor redemptions in an orderly manner then suspending redemptions for a short period of time may be necessary,” Mr Miller told WealthBriefing.

“At Cheviot we generally use fund of hedge fund managers to gain exposure to the sector. Diversification reduces the impact of a problem with an individual manager. One of the factors that we focus on is making certain that the liquidity terms offered to us by the fund of funds is consistent with the range of notice periods for the funds that they invest in,” he said.

One of the hardest-hit hedge fund sectors in recent weeks has been energy, as the reversal of some commodity prices such as oil has caught funds out who had been bullish of the market.

Last week, the Swiss-based investment firm Gardner Finance said its Gardner Energy MacroIndex, which tracks actively the performance of energy hedge funds, lost 5.78 per cent in July this year.

It is no surprise that at times of stress, a lot of investors are wondering how easy it is to get out of a fund. But hedge funds are no different from the most humdrum insurance policy or other financial product: read the fine print.