By banning short selling of financial stocks, securities regulators in Australia, Britain and the United States may have inadvertently added to the risk that the next down-leg of the financial crisis could involve a death spiral among hedge funds. This has been a grim year for the hedge fund community, which has been hit hard by the credit crunch and subsequent financial crisis. Overall, the industry has lost money, with the Credit Suisse/Tremont Hedge Fund Index down 3.55 per cent for the year to August (see the first chart below). That performance might not seem too bad, especially when major stock indices have fallen 20 per cent or more. But the decline gives the lie to hedge fund managers' claims to be able to profit in falling as well as rising markets, and will inevitably dent investors' enthusiasm for the sector. Few hedge fund managers are listed, but the shares of those that are have suffered heavily lately, with the London-listed Man Group down 40 per cent in the last three months (see the second chart). Even worse, the modest drop in the industry-wide index masks the dismal performance of some popular hedge fund strategies. According to Credit Suisse/Tremont, funds specialising in convertible bond arbitrage were down 8.2 per cent for the year to August, while emerging markets hedge funds had fallen 10 per cent. Hedge funds operating in Asian markets have performed even more poorly, losing on average about 20 per cent of their investors' money in the first eight months of the year, according to some estimates. Given the state of regional markets, most will have lost heavily in September, too. Not surprisingly, hedge funds that specialise in short selling have done much better, gaining 10 per cent for the year to August. But now that regulators have banned shorting, hedge funds that employ the strategy, which include long/short equity funds and market-neutral specialists as well as dedicated shorts, are in trouble. Many investors may well reason that if hedge funds have been forbidden to go short in a falling market, there is not much point in owning them, and that they might as well cash out. Poor performance for the year to date and the short-selling ban are not the only reasons for investors to get out. With major economies heading into recession and the prospect of corporate defaults rising, many hedge funds are threatened with the prospect of massive losses on the trillions of US dollars worth of default insurance they have sold through the credit derivatives market. If this year's performance has been bad, next year's could be worse. This could get ugly. Hedge funds typically restrict investors to quarterly redemptions and some require three months notice of withdrawals. The industry was already facing heavy redemptions at the end of September from investors that applied to cash out in June. Now, with markets tumbling and investors' risk aversion rising, rumours are flying around that this week saw an unprecedented level of applications to withdraw funds at the end of December. The risk is that although many funds are holding high levels of cash at the moment, some will be forced to sell assets to meet investors' redemptions. That will drive down asset prices, exacerbating hedge fund losses and triggering more redemptions, which in turn will require even more asset sales. The trickle could soon become a torrent and the torrent a cascade, in a classic example of the dreaded death spiral. The effect on markets would be devastating. Hedge funds manage about US$2 trillion of investors' funds but leverage up between 5 and 20 times. So if 10 per cent of investors try to get their money back, they could trigger forced sales of assets worth more than US$1 trillion. An unravelling of such magnitude would prove fatal for many hedge funds and would inflict immense collateral damage on ordinary investors. And while it would be going way too far to place all the blame on the regulators, their ill-considered ban on short selling might just prove the last straw that breaks the hedge fund camel's back.