A nice article on hedge funds

Donald MacKenzie has written a nice article on hedge fund industry- practices, strategies and problems. Read the Volkswagon case-study:

Situations in which many hedge funds have similar or identical positions are called ‘consensus trades’ or ‘crowded trades’. Every so often these cause sudden, huge movements in prices that have little or no basis in economic fundamentals such as the prospects for the firm, sector or country at issue.

In the last week of October, for example, Volkswagen briefly became the world’s most valuable company by market capitalisation, but not because investors were suddenly struck by how attractive its cars were or by optimism about the prospects of the motor industry. Rather, a consensus trade had gone disastrously wrong. Volkswagen’s ordinary shares had started 2008 half as expensive again as its preference shares, and the difference had soared during the year.

The holders of preference shares can’t take part in shareholder votes, and they receive a fixed rate of interest rather than the fluctuating dividends offered by ordinary shares, but both kinds of share are stakes in the same firm, and it seemed reasonable to conclude that the growing difference between their prices was an anomaly that would correct itself. So a large number of hedge funds – some say as many as a hundred – bought Volkswagen’s preference shares and short sold its ordinary shares. These matched long and short positions meant that the funds were insulated from overall fluctuations in the company’s fortunes: it ‘was meant to be a low-risk trade’, as one London fund manager told the Financial Times.

Unfortunately, Porsche, which already owns 42.6 per cent of Volkswagen’s ordinary shares, had quietly been increasing its stake by buying call options (a call option is a contract that gives you the right to buy an asset at a fixed price). If it turns all those options into Volkswagen shares, Porsche will own 74.1 per cent of them; the government of Lower Saxony owns a further 20.2 per cent that it’s very unlikely to sell. That would leave only 5.7 per cent of Volkswagen’s ordinary shares available to be traded on the market. However, hedge funds and other traders had between them short sold shares equivalent to 12.9 per cent of the total, and in consequence were obliged to buy and return them. They understandably panicked, and the resultant frantic efforts to buy Volkswagen shares caused the price to quadruple.

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