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Is Hedging Bets Worth the Trouble?
By Stephen J. Butler |
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In the Walt Disney movie "Fantasia" there is an animated scene of dancing hippopotamuses that calls to mind how the worlds of mutual funds and brokerage firms intersect. Meanwhile, I've learned from the Discovery Channel that, in real life, the hippo is the most dangerous and unpredictable animal in Africa. Together, these images remind us that we need to be circumspect and well informed when exposing our
retirement savings to these institutions.
I just finished reading James Cramer's book "Confessions of a Street Addict," which offers a rare glimpse into the inner workings of Wall Street. This autobiography of a hedge fund manager is refreshingly candid as to how the inner workings of the market are like the layers of an onion. We, the investing public, typically see just the outer layers, but Cramer slices the onion in half and the result is a tearjerker of sorts.
Cramer's wife Karen proves to be the real brains of his company. By far the most experienced at the start, she set the budding young hedge fund manager straight by saying, "You want to buy stocks because you think they are cheap or something? You want to be at the mercy of the market? Be my guest. But you will never make it as a hedge fund manager."
A hedge fund, by the way, is a mutual fund for investors who can show that they have at least $5 million in liquid assets. Because such people are assumed to be reasonably sophisticated, the partnerships they join are not required to demonstrate all the same safeguards as a mutual fund sold to the general public. A hedge fund, for example, can borrow to buy stock, which increases its leverage and its risk. Hedge funds can also sell short which enables them to profit when a stock drops in value.
To sell a stock short, you borrow some stock from a current holder and sell it to receive cash. You pray that the stock goes down in value over the next few months so that you can spend some of your cash to buy the shares you need to return to the share lender. If all goes well, you get to keep the difference between the proceeds of your initial sale of borrowed stock and the money you needed to pay later to "cover" your short and return the shares to the lender. A disaster can occur when the shares go up in value instead of down. Now, you have to invest more than the cash you originally received to buy what may have become very expensive stock that needs to be purchased to pay back the original lender. Short sellers in this bind are said to be "squeezed." The demand created by enough people with the same problem can cause the price of the stock to go up even faster as these self-styled "masters of the universe" struggle to buy enough shares to unwind their positions on a runaway train.
The brokerage industry loves the hedge fund industry because huge amounts of brokerage commissions are generated by all the stock trading and borrowing that transpires. The brokers who get the business are those who can tell hedge fund managers what trades the fund companies are struggling to execute. Why is this valuable? Here's a simple example. A mutual fund's unloading of one million shares will flood the market over a few days and will drive the price of even a large company's stock down from, say, $26 to $24. The hedge fund manager wants to be standing in line to purchase that last 200,000 shares at $24. A few days later, when the market has absorbed this huge transaction, the stock will have gravitated back to its original $26. As Warren Buffet says, "there have always been market inefficiencies." This means that the short-term price of stocks does not always reflect the fundamental profit picture of the company. Hedge fund managers prey on these inefficiencies and make a lot of money.
Mutual fund managers, for their part, are under tremendous pressure to look good at the end of a quarter. If they already own a large position in a stock, they will often buy more in the closing days of a reporting period to boost demand and bump the price of the stock. Even with a huge company like GE, the purchase of 500,000 shares can create enough demand to bump the price of the stock by a few points. Some managers are more notorious than others for this practice, but the stakes are high. Advertising dollars within a fund family are allocated to the funds that generate the best gains from quarter to quarter, so managers are highly motivated to generate good results as of the end of a quarter. More advertising leads to more money attracted to the fund and more compensation for the manager. A hedge fund manager tipped off as to which mutual fund managers are adding to positions can "piggy back" on the inevitable gain.
One of the best parts of the book is the description of the IPO of Cramer's other company, "TheStreet.com." Cramer's account of this transaction captures all of the silliness of the dot-com era, but it also illustrates the inner workings of an initial public offering better than anything I have ever read. TSCM was underwritten at $19 but came out with opening bids at $63 and went to $70 before its inevitable plummet to about $1.00. (It's now approaching $3.00)
The lesson, of course, is that it is futile to try to be a successful short-term investor or market timer. Attempting to second-guess the machinations of the players in the public markets from a den at home is
sheer lunacy. The book leads us to other conclusions as well. For example, a smaller fund with cheaper annual fees and next to no advertising will probably be operated with a greater eye to our interests. It can get in and out of stocks without riling the markets, and it will not be wasting what could have been our money soliciting new investors.
Considering its basic subject matter, Cramer's book is surprisingly entertaining and one I would highly recommend. To better understand how a few players on any given day can influence the stock prices of huge companies, I would refer readers to a previous column entitled "Marked to Market" which explains a vaguely understood concept of stock pricing. This piece has been used as class material at UC Berkeley business school.
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