Tag Archives: hedge funds

short selling as an investment tool: risk arbitrage

October 4, 2010 By in Basic Concepts, black knight, hedge funds, Investment firms, Risk Arbitrage, short selling, white knight Tags: , , , , , , , Leave a comment

what it is

Risk arbitrage is an investment strategy based on exploiting pricing anomalies in mergers and acquisitions.  It’s one of the older hedge fund-like activities in the financial markets.

Let’s say that company A, which is trading at $30 a share, announces a bid to acquire company B, which is trading at $50 a share.  The bid is for stock, at a proposed rate of two shares of company A stock for each share of company B.

after a bid is announced

The bid will have two consequences:

–company B is “in play.”  Chances are it won’t survive as an independent company.   B’s top management and board of directors will be focussed on obtaining a higher price than A has initially offered, and possibly on finding a more suitable (or la least, different) merger partner (see my post on black and white knights).

–the way professional investors evaluate B’s stock changes.  Right now, and for as long as acquisition is a possibility, B’s stock no longer exists as an independent thing.  In the simplest case, one where the merger is friendly, no other bidder is in sight, regulatory and shareholder approval appears assured and the date for merger is also reasonably certain, B’s stock is already A’s stock under a different name.

In this case, the arbitrage is straightforward.  Shares of A are trading at $30.  Shares of B, which are really A shares in disguise, are trading at $25.  Therefore, the arbitrageur buys B and sells A short until the two prices–adjusted for the cost of money until the merger is completed–converge.

Life isn’t always this simple.  Arguably, a skillful risk arbitrageur doesn’t want it to be, either, since in the plain vanilla case just described, the arbitrage opportunity is gone in a flash.  The arbitrageur’s analysis of a bid situation typically has three parts:

1.  What is the true value of company B to a trade buyer, or–arbitrageur’s nirvana–a private equity firm?

2.  What are the chances of achieving this value?  In particular, who would pay the full price?  …will that entity bid?  …what regulatory obstacles would he face?

3.  What happens if the bid on the table is withdrawn?

The calculation of the price B should be trading at is a straightforward expected value.  The arbitrageur’s decision to buy or not will be a return on invested funds keyed off it.

what the price of B is saying

Figuring that it would take six months after announcement for an agreed merger to take place, the cost of funds should only amount to one or two percent of the price paid for B shares.  In this case, B shares should initially trade, I think, somewhere around $57 (remember it’s a 2-for-1 deal) and gradually drift up toward the $60 offer price.

Sometimes, the price of B spikes above the offer price.  This usually indicates that arbitrageurs believe a better bid is in the offing, either from company A or from another party.

Sometimes, the price of B goes up, but only modestly.  This typically signals arbitrageurs’ beliefs that regulatory or other hurdles diminish the chances of the combination ever taking place.

Occasionally, the price of A will drop sharply, indicating the stock market doesn’t like the deal at all.  In an agreed merger, this will drag B’s stock down with it.  Often, there’s good reason for investor worry.  On the other hand, a bid announced in March of last year would doubtless have unleashed a torrent of selling in A’s stock.

before a bid–prospective arbitrage vs. value investing

Actual arbitrage is event-driven.  What do arbitrageurs do all day if all their capital is committed to deals?  Like other professional investors, they go to conferences or to the gym.  Maybe they blog, although that would be hard to get past the compliance department.

On the other hand, what if there are no deals?  Sometimes, arbitrage firms try to anticipate areas where merger and acquisition activity may be brewing and buy shares of likely acquisition targets.  When I started writing this section I was tempted to say that in doing so, these firms act just as ordinary value investors would.  While it’s true that growth investors end up holding acquirers and value investors their targets, I don’t think my thought is quite right.

It is possible, I think, to identify broad areas where, conceptually at least, industry consolidation is likely.  For example, when the EU began to drop customs controls at the borders between member countries, this unleashed a multi-year wave of mergers and acquisitions in the grocery industry.  Supermarkets wanted to rationalize their distribution networks and achieve larger scale to give them more bargaining power with their suppliers.  This, in turn, triggered a second wave of consolidation, this time among packaged goods companies, as they sought to reestablish their negotiating advantage over the supermarkets.

At present, the computer hardware and software industries strike me as ones where consolidation will continue.  Also, China seems to me to be very eager to turn its dollar holdings into physical assets by buying companies that either will provide that country with natural resources or that will be distribution outlets for its finished goods.  Washington, however, like Paris, seems bent on preventing this from happening in the US.

Causes of the May 6th “flash crash”: the SEC/CFTC report

October 3, 2010 By in day trading, hedge funds, Recent Market Action, securities markets, stock market, Trading Tags: , , , , , , , Leave a comment

Last Friday, the Securities and Exchange Commission and the Commodity Futures Trading Commission issued their joint report on what caused the sudden drop in stock prices on Wall Street in mid-afternoon on May 6th.  The full report is 87 pages–plus some colorful charts–long.

The first eight pages give a summary of the findings, which MarketWatch has edited–that is, deleted the footnotes–and presented in two pages that are easier on the eyes.

some background…

1.  I posted twice about the mini-crash when it occurred.  Here are links to the first and second post.

2.  Traditional investment management companies, seeing the appeal of hedge funds to their client base, have created their own hedge fund-like offerings over the past half-decade.  Some have become very popular and are now very large.  One of these, unnamed in the report, triggered the market fall when it placed a large computer-controlled order to sell a specific stock index futures contract, the E-mini S&P 500.

3.  One of the tactics day traders use is to scan the market for unusual movement–up or down, it doesn’t matter–in stocks whose trading patterns they feel familiar with.  When they see abnormal pressure, they’ll step in to take the other side of the trade.  They figure the pressure is temporary and that when it ends the stock will revert to its normal trading level.  They’ll then unwind their position at a profit.  For longer-term market participants, day traders provide a useful liquidity-enhancing service that allows them to shift money from one stock to another more quickly.

4.  Brokers, and especially the big discount brokers catering to individual investors, have their own internal market-making operations.  They try, if possible (they have to abide by rules on searching for better prices from third parties), to match, in-house, one customer’s buy order with another’s sell.  This way, they earn the bid-asked spread, which can be much more than the commission they charge.

The report calls firms that do a lot of this “internalizers.”  There’s nothing necessarily wrong with doing this, either.  After all, someone is going to earn the spread.  The relevant point is, though, that  under normal conditions this order flow never hits the NYSE or other exchanges.

…to understand what happened on May 6th

At 2:32 pm on May 6th, the unnamed mutual fund company initiated an order to sell 75,000 E-mini S&P 500 futures contracts (about $4 billion worth, or a few percent of typical daily trading volume).  They told the SEC/CFTC they did this to try to protect stock positions against losses in a market that had been drifting downward for about two weeks.  The E-mini, traded on the Chicago Mercantile Exchange’s Globex electronic trading platform, is preferred by many to other contracts that are traded using the older “open outcry” (that is, yelling) system.

The portfolio manager who placed the order gave two instructions to his trading desk:

–the order was to be executed by computer, not by a human trader, and

–the order would be fed into Globex in amounts no more than 9% of what had been traded in the prior minute.

The manager could have given other instructions–say, put in a price limit, or a specification of a maximum amount of the order to be done before checking with him/her–but didn’t.

The institution had apparently done an E-mini sell this large only once before.  On the prior occasion, the trade was done partly by humans, partly by computer, and took five hours.  Maybe it didn’t work out as well as the initiating portfolio manager would have liked.  In any event, this time the manager put the order right to the computer, cutting out the human fail-safe.

Either by accident or portfolio manager design, the May 6th trade was completed in 20 minutes, leaving a securities market train wreck in its wake.

(The SEC/CFTC report simply records the fact of this trade.  As someone who has worked with various kinds of trading rooms for three decades, however, I find the account of the trade really strange.

This was a $4 billion order, so a senior person placed it.  Yet, he/she doesn’t seem to have realized how huge it was–it and the earlier sell order were two of the largest three one-day sells in the E-mini of the prior year. At the very least, he/she seems to have made no provision to monitor the trade, even though a new procedure was being used.

No one at the firm seems to have sensed that the trade was having negative ripple effects on the financial markets.  Apparently, no one tried to stop the trade before the 75,000 contracts were sold.  The issue isn’t necessarily that one should have a social conscience, although the firm may well have damaged its professional reputation.  Again, no comments from SEC/CFTC, but the trade execution must have been at terrible prices. Comments in the SEC/CFTC report do suggest that the portfolio manager involved had little grasp of basic features of the E-mini market.)

the order hits the market

As the order began to be executed, short-term traders did their thing.  They took the other side of the trade and sat back to wait.  When the selling stopped, they planned to reverse their positions at a profit.   That would pay for the big lunches they’d just had, or maybe for summer camp for the kids.  Some day traders also looked for discrepancies between futures prices and the physical market and hedged–transmitting, as usual, the futures market action into physical stock trading.

But the mutual fund computer didn’t stop.  Day traders started to get worried, and started to offload some of the risk they had taken on that day, both from this trade and others.  In other words, they started selling, too.  Their defensive behavior had the perverse effect of increasing E-mini volume, however. That meant that, although counterparties were signaling that they didn’t want to trade any more, the mutual fund computer obeyed its instructions and upped the speed of its selling.

Several things happened next:

–market makers either stopped making markets entirely or set bid-asked spreads that they thought only a crazy person would act on,

–which caused a trading halt in the E-mini, helping that market to stabilize and recover.

–retail investors, nervous after two weeks of decline, bad economic news and the market dropping that day, panicked and placed market orders to sell physical stock as well, and

–at least one big “internalizer” effectively shut down in-house operations and directed a big wave of sell orders to third parties–where the loony bids and asks resided.

After twenty minutes, punctuated by the saving grace of the trading halt, the mutual fund computer was sated and shut itself down.  The market rebound was already under way.

lessons learned

I imagine that one person has learned that you shouldn’t put in an order to sell $4 billion worth of anything–especially something new–without watching for a while to see what happens.

The rest of the world has learned that accidents like this can happen.  Presumably, the next time the markets won’t panic as much.

At the end of the day, the exchanges and FINRA (Financial Industry Regulatory Authority) huddled together and decided to void all trades that were more than 60% away from a reference price they determined.  Two aspects of this decision troubled market participants:  it came after the fact, and the process wasn’t clear.  Since the exchanges and FINRA represent the brokers, the natural suspicion–correct or not–is that they cancelled mostly trades they lost money on.  Not an idea that encourages buyers during market declines.

The SEC and FINRA have since developed a set of rules to cover what trades, if any, will be voided as/when this kind of market decline recurs.


short selling as an investment tool (II): hedged vs. unhedged

October 1, 2010 By in Basic Concepts, Constructing a Portfolio, Industry Analysis, Investment firms, Portfolio management, Risk Arbitrage, short selling, Strategy Tags: , , , , , , , , , Leave a comment

Short selling is involved a number of hedging strategies.  Short sellers, however, like any investors, can run both unhedged and hedged positions and portfolios.

Unhedged

It’s important to distinguish between a hedged position and a diversified position.  Both are ways of reducing risk.  But they’re not the same.  Diversification is having three cows in case one stops giving milk.  Hedging is having one cow but taking out an insurance policy in case the animal drops dead.

You can have a diversified portfolio consisting solely of short positions, just as you can have one that is made up completely of long positions.  In both cases, you’re at least somewhat protected against the risk that one or two positions go wrong.  But in the former case, you’re still exposed to the possibility that the overall market rises sharply.  In the latter, you still have the risk of a sharp market decline.

Dyed-in-the-wool short sellers run unhedged short portfolios.  Operating this way means taking on a lot of risk, and requires a person who is temperamentally suited to the short side and has a considerable degree of skill. The reason is the more open-ended possibility of loss if the positions move the wrong way. But the structure is pretty straightforward.

You can have as an objective either to have the names you’re short to lose money in absolute terms, or simply to underperform an index like the S&P 500.

Hedged

It’s much more common for short positions to be components of a hedged portfolio, that is, one that includes long positions as well.  Three ways to do this:

1.  One of the oldest instances of hedged portfolios is risk arbitrage, a merger and acquisition strategy, where a manager typically buys the stock of the target and sells the acquirer short, after a deal is announced.  More about this in a post next week.

2.  Another is the original hedge fund, what would be called today a market-neutral strategy, where the manager holds equal dollar amounts of both long and short equity.  If you were to read the marketing literature for this kind of portfolio, the managers might say things that would lead you to believe that by doing so they have hedged away the risks associated with overall market movements.  Maybe so.  Personally, though, I think it’s very hard for a manager not to let a directional bias–his thoughts about where we are in the business cycle–seep into both long and short active positions.  In other words, if you think the market is going down, you’d be short cyclicals and long defensives, and vice versa.)At the very least, performance has two components:  (out)performance of the long positions against the index pus (under) performance of the shorts.

3.  What are called pair trades have become popular over the last decade or so, both with high net worth individual investors and with modern hedge funds (which, to my suddenly curmudgeonly eyes, have nothing more than a fee structure in common with the traditional ones described in the last paragraph).  Pair trades consist of two stock ideas, one long and one short, typically both in the same industry and probably covered by the same industry analyst–who is the one suggesting the trade (and hoping the management of the company on the short side doesn’t find out).

The concept is to reduce the active bet you’re making to one about the relative operating efficiency of two companies in the same or allied industries.  In theory, factors relating to the strength of the global economy or the health of the industry involved are taken out of the equation this way.  Like the market-neutral strategy, gains or losses are supposed to come from what’s different about the two members of the pair.

Examples from the recent past might be:

Long Toyota, short GM

Long HP, short Dell

Long McDonalds, short Starbucks

or even

Long Wal-Mart, short Target (weak economy)

Long Target, short Wal-Mart (strong economy)

In the first two cases, the contrast is between strong management and weak management (of course, Toyota turned out not to be so strong in the end).  In the last three, and very clearly in the last two, strength/weakness of the economy has snuck back in.

My thoughts

Pair trades—small positions only!—while riskier than simple long positions and requiring careful/continual monitoring, strike me as okay for individuals to try their hands at.  The rest of the short-related world–hedged or not–should be left to professionals.

short selling as an investing tool (I)

September 30, 2010 By in Basic Concepts, hedge funds, Portfolio management, short selling, Strategy Tags: , , , , , Leave a comment

Yesterday I argued that there’s a long-term tendency for the stock market (in any country outside Japan) to rise.  There are two reasons:

–national monetary policies are set up to avoid deflation by encouraging mild inflation, so nominal prices generally rise; and

–at least some people aspire to economic gain, or to creating new products and services, so in the absence of government policies that discourage these activities, real GDP also tends to rise.

Where does this leave short selling?

As it turns out, my first portfolio job–after four years as an analyst–was (luckily for me) working for an extremely skilled investor on a short portfolio.  So I know a little about the subject.

I’m going to write about this topic in two posts.  Today’s will cover the basics.  Tomorrow’s will be about hedging techniques used to control the substantial risks that shortsellers take on.

why professionals find shorting attractive

Two factors make short selling theoretically attractive, even in a world where stock prices generally rise:

creative destruction:  Often, the rise of a new product or service sounds the death knell for an older competitor who is unwilling or unable to adjust.  Specialty retailers began to replace department stores in the move to the suburbs thirty-five years ago.  They are being supplanted now by on-line commerce, as well as by the reemergence of more flexible generalists like WMT and TGT.

less competition:  Most professional investors gravitate toward the long side and toward fast-growing new industries.  As a result, there may be four or five sharp minds looking at every long idea for every one looking at a short.

why it’s not for everyone

1.  I think shorting is harder than buying a stock you think will go up.  The long side has many types of specialized investors.  For instance, there are large cap and small cap specialists, value investors and growth investors, special situation investors.  For a stock to rise, one of these groups has to like it.

But for a short idea to go down, everyone has to dislike it.  Not only do you have to have a certain quirky turn of mind (a kind of Schadenfreude) to be a successful shortseller.  You also have to be able to put yourself in the place of groups with different parameters for what makes a good stock and think out why your potential short won’t interest any of them.

2.  It’s riskier to short stock than to be a buyer.  When you short a stock, you borrow shares from someone else and sell them.  You  hope you can buy them back later on at a lower price, so that you can return them to the original owner and close out your position.

In the meantime, you have to post collateral, which is held by a third party.  The amount of the collateral needed to support the short position goes up if the price of the stock you’ve shorted rises–sort of like margin debt in reverse.  Two implications:

–you can be absolutely correct, but being early, with an insight that runs counter to the mass mind of the market, can be a killer.  Suppose, for example, you thought MSFT’s best days were behind it at $35 a share in early 1999 and shorted it then.  You would have been right on a two-year view.  But in the intervening time the internet craze drove the stock up to close to $60.

It would have been an even more testing experience if you thought PMC Sierra (PMCS–now a $8- stock) was over valued at $50 in late 1999.  Again, you would have been right on a longer-term view.  But that stock, smaller and zippier than MSFT, flirted with $250 a share both in early and in late 2000.

Yes, PMCS and other internet-related chipmakers were unusual cases.  But the fact remains that in any short you run the risk of running out of collateral and having to cover your position at a substantial loss before the world realizes you’re right.

–a related risk, though more of a worry for professional shortsellers than for you and me.  Your broker can change his mind about your creditworthiness and increase the amount or type of collateral he requires.

That’s it for today.  Hedged vs. unhedged shorting tomorrow.



more on absolute vs. relative performance

September 29, 2010 By in Absolute vs. relative performance, Basic Concepts, Portfolio management, Strategy Tags: , , , , , , Leave a comment

One of the earlier posts I wrote on this blog had to do with absolute vs. relative performance.  I reread it today and am generally satisfied with what I wrote then.  One exception, though.  I think the post came at the topic from the rather narrow perspective of a professional investor, who is already convinced that the best way–or at least one good way–to achieve absolute performance is to try to achieve relative results.

In this post, I’d like to broaden my discussion of the topic by adding two observations, one psychological, the other economic:

1.  One of the most important of the (many) clichés Wall Street uses is that market turns, especially upturns, come out of nowhere and catch most investors by surprise.  Not only that, but the initial move up can cover a lot of ground in a short time.  Missing this initial surge, so the argument goes, is virtually impossible to recover from.  Brokers typically cite academic studies that the greatest part of the market’s gains over a business cycle come in only about 10% of the trading days.  Be out of the market on those days and you’re toast.

I think there’s something to that argument.  I’d like to add my own twist to it, though.

In my experience, lots of professionals can either tell when the market is getting toppy or when it’s stunningly cheap.  But I don’t know anyone who has been able to do both.  Wall Street is a very gossipy place, so if there were such a person, word would get around–despite the individual’s desire to keep his ability to time the market a secret (so others wouldn’t begin to study his every move and his skill would remain his edge alone).  In addition, just off the top of my head I can think of three former professional acquaintances who “called” the top of the market, one in 1984 and two in 1986, with disastrous results for both them (two were fired) and their clients.

Look at the record of hedge funds, whose aggregate performance failed to match that of the S&P 500 every year since 2003.

Anyway, I think some investors have bearish temperaments and can call tops but not bottoms.  Others, like me, have a bullish cast of mind.  We can call bottoms but not tops.

2.  Assume that we live in a world that’s characterized by:  a) inflation; and b) economic growth.  Each implies that stock prices will tend to rise.

a.  Modern economics comes out of systematic study of the Great Depression of the 1930s.  One of the highest goals of monetary policy around the world is to avoid a recurrence.  In particular, the world wants to avoid a repeat of the deflation that marked that period.

Other than in the case of Japan, which has consistently chosen to have deflation rather than permit structural societal change, the world has been successful in doing so.  Let’s suppose (and fervently pray) that this continues.  What does this mean for stocks?

Stocks are priced in nominal terms, in dollars of the day.  But they represent ownership claims on real assets and business operations.  Inflation means that nominal prices in general are rising.  So there should be a tendency for the nominal value of the corporations whose shares of stock are publicly traded to rise as well.  Ultimately, this should translate into a tendency for stock prices to rise, even in the absence of real economic growth.

b.  But, as an empirical observation, there’s real economic growth all over the place.  The US economy, which has been closer to the caboose of the world economic train than the locomotive, is still 50% larger than it was a decade ago.  New nations have entered world commerce.  We have notebooks, netbooks, tablets, iPhones, iPods, social networking, online shopping, biotech, medical advances–lots of stuff we didn’t have ten years ago.  Why?  …because many people around the world like to build and invent new things.  Publicly traded firms–where else do entrepreneurs get the money they need to grow their companies–participate very substantially in this growth.

My point is that the path of least resistance for stocks–due to inflation and to real economic growth–is up.

Yes, I believe what I’ve just written is true.  Maybe it’s a cartoon version of the truth, but it’s true.  That’s not really what I’m trying to convey in this post, though.  What I want to say is that professional investors in general opt to try for relative performance rather than absolute because they believe this, too.