Thursday, July 17, 2008

A hedge fund in action

Hedge funds are usually passive position holders, meaning that even though they might have a pretty decent stake in a company, it will not usually use that stake to try and take over boards (unlike say the Jerry Yang/Yahoo board versus Carl Icahn ongoing saga), though it will of course keep a big bad eye on the operations of its bigger holdings. What this essentially means is that a hedge fund is a "passive investor" and not an "active" one. However, hedge funds, are trading entities and seldom will they let a good trading opportunity pass.

A recent development occurred in a commodity play in the US equity market this week that shows how hedge funds can suddenly turn active investors in search of a very profitable trade and thereby hurt the retail/individual investor heavily.

The background: Yesterday Cleveland Cliffs (CLF), USA's biggest iron-ore producer announced that it would acquire Alpha Natural Resources (ANR), USA's biggest coal exporter, for 8 billion USD+, the offering included a 35% premium on ANR's current share price.

Now those who follow the market will know that commodities are in a bull market and both these companies have been flying fast and high over the last 1 year. So obviously when these two top dogs decided to merge, shareholders expected a huge surge in the price pf both.

Hedge fund comes in: But curiously after a small rally, ANR's shares started to plunge in an alarming rate and as of today ended up trading lower that CLF's, completely confusing me and all other individual/retail investor, as this completely defies all logic. A company offered a premium over its current share price, cannot by any logic trade below that price.

Well on further digging we found that
Harbinger Capital, an Irish based hedge fund, which owns 18%+ of Cleveland Cliffs - informed the co. they were going to be fighting it. That is they believed this deal to be against CLF's interest and suddenly turned an "active investor" from a "passive one", creating a huge short opportunity for the big money (hedge funds) causing the price to plunge.

The follow up play after Harbinger's decision for hedge funds would be --->Short ANR--> ANR plunges-->make profits on the drop in ANR due to this decision--> get out of the short position with a killing--->explains the complete weird stock price behavior of ANR

Hedge fund's fundamental trait: Remember, that unlike a value investor like Wbuffet, HFs have no interest in improving a company's operations and such things, they are in there to make profitable trades. And this sudden filing made for a perfect trade. Moreso if you understand that this deal would ,infact, have been a booming winner for CLF !!

Moral: Follow the big money, follow where HFs are going in and out of. But right now the HFs are really working in a weird and unpredictable manner, mainly because the downright wretched US market has completely spooked them and most of them are losing a LOT in this market, something which their investors are definitely not going to like. Remember HF investors are wealthy affluent folks (high net worth individuals) who put in obscene amounts into these HFs and therefore the HFs have to work under tremendous pressure to generate big returns for them or else have those funds pulled out , even in shabby bear markets like we have now. It is pretty funny to track these HF panic buys and sells in the current bear market. The trades are downright whacky !!

Now for the million $ Question:

OMG HowTF is this relevant to my MBA: For somebody interested in the buy side of finance, understanding of the market is almost a necessity. You cant just land up in B-school, and suddenly become a star trader overnight. Like any sport, learning trading and way trades are being done is a long drawn learning process with a fairly steep learning curve, not an overnight "stock -pitch" cram.

Disclosure: Long ANR in personal account

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