What Is a Run on the Fund?
A run on the fund is a situation in which a hedge fund, or other asset pool, faces a growing number of requests for redemptions from investors. A run on the fund may happen for several reasons, but is usually the result of poor performance of underlying assets. This poor performance motivates investors to request the return of their money, which in turn causes the fund to exit its positions, leading to even worse performance and more redemptions, usually leading the hedge fund to ultimately shut down.
A run on the fund can be compared with a bank run, where depositors flock to withdraw their deposits all at once, causing the bank to run short of cash and eventually collapse.
- A run on the fund is when investors in a pooled investment such as a hedge fund suddenly and all at once request their money back via redemptions.
- Often triggered by poor performance, a run on the fund compounds problems by forcing fund managers to exit positions at increasingly unfavorable prices, and inducing even more redemptions.
- Ultimately, a run on the fund can cause a hedge fund to shut down and go out of business.
Understanding Runs on the Fund
A run on the fund gains momentum as fund managers are forced to sell assets to meet redemption requests. These forced sales often negatively affect the performance of the fund, especially during a bear market. As the market falls, fund managers need to sell assets to raise the necessary cash, and often must sell at a loss. As redemptions further depress the fund's performance, more investors become frightened and request redemptions, causing a negative feedback loop that in many cases can force the fund to close.
Many hedge funds defend against runs by allowing managers to suspend the investors’ ability to redeem for a period. Before the 2008 financial crisis, such suspensions were extremely rare, as they signaled to investors that the fund was struggling and may even be forced to close. But during the crisis, many large, famous hedge funds, like hedge fund pioneer Paul Tudor Jones’ BVI Global Fund, suspended redemptions to prevent a run on the fund.
Example of a Run on the Fund
Peloton Partners suffered a classic run on its $1.8 billion mortgage-backed hedge fund in 2008, after the crash in U.S. real estate prices severely damaged Peloton’s performance. Peloton bets against the subprime real estate and invested heavily in higher-grade mortgages, which enabled it to earn an 87% return. But, as the crash continued, even Peloton’s higher-grade investments began to sour. The firm suspended redemptions to prevent investors from fleeing en masse, but these measures were too little, too late. Peloton announced in February 2008 that it was closing its mortgage-backed fund.
A run on the fund is not just limited to hedge funds. In 2008, a prominent money-market mutual fund called the Reserve Primary Fund suffered a run as the result of its investment in the short-term debt of the failed investment bank Lehman Brothers. Though the fund kept just a fraction of its investments in Lehman debt, spooked investors withdrew nearly two-thirds of the fund’s total assets under management within days of the collapse. Though the fund suspended redemptions, it was not enough to prevent its ultimate failure.