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Woodford. The thrill has gone

Panacea comment for Financial Advisers & Paraplanners

14 Aug 2019

Woodford. The thrill has gone

Last week, Woodford investment saw crashes after short-seller attack. 

In situations like this I often turn to the blues for some short sharp analytical lyrical inspiration of the situation. In this case to quote Muddy Waters (not that firm) but the blues-man’s song ‘Rolling and Tumblin’.  

A line goes “Well, I woke up this mornin', didn't know right from wrong” 

The shares of one of the largest investments in the stricken Woodford Equity Income fund have collapsed after a short-seller revealed it was betting against the company's shares. 

Not sure about the ethics here?

Shorting has been around a very long time, it is how hedge funds make money.

Hedge funds caused the 2008 financial crisis by adding too much risk to the banking system. That's ironic because investors use hedging to reduce risks.  

They use sophisticated, data-based investing strategies. It allows their analysts to find out more about individual companies than an average investor could. They exploit and take advantage of any unfairly priced stocks. That makes share prices more fairly valued. 

To draw further from Kimberley Amadao, who wrote earlier this year about Five Factors That Made Hedge Funds So Risky 

Hedge funds also increase risk.

  • Their use of leverage allows them to control more securities than if they were simply buying long. They used sophisticated derivatives to borrow money to make investments. That created higher returns in a good market and greater losses in a bad one. As a result, the impact of any downturn was magnified. Hedge funds derivatives include options contracts that allow them to put down a small fee to buy or sell a stock at an agreed-upon price on or before a specified date. They can short sell stocks, which means they borrow the stock from the broker to sell it and promise to give it back in the future.
  • They buy futures contracts that obligate them to either buy or sell a security, commodity, or currency, at an agreed-upon price on a certain date in the future.
    As a result, hedge funds' impact on the stock market has grown substantially in the last decade. According to some estimates, they control 10% of shares on U.S. stock exchanges. That includes the New York Stock Exchange, the NASDAQ, and BATS. Credit Suisse estimates their impact could be even higher. They may control half of the New York and London Stock Exchanges. (Source: "U.S. Regulators Grow Alarmed Over Hedge Fund Hotels,” International Herald Tribune, January 1, 2007.)
    Since they trade often, they are responsible for one-third of the total daily volume on the NYSE alone. An estimated 8,000 hedge funds are operating globally. Most are in the United States. There is a high concentration in the state of Connecticut.
    Researchers found that hedge funds contribute positively to the stock market. But when their sources of capital dry up, they can have a devastating negative impact. (Source: Charles Cao, Bing Liang, Andrew Lo, Lubomir Petrasek, "Hedge Fund Holdings and Stock Market Efficiency," Federal Reserve Board, May 2014.)
  • They all use similar quantitative strategies. Their computer programs can reach similar conclusions about investment opportunities. They affect the market by buying the same product, like mortgage-backed securities, at the same time. As prices rise, other programs get triggered and create buying orders for the same product. 
  • Hedge funds are still largely unregulated. They can make investments without scrutiny by the Securities and Exchange Commission. Unlike mutual funds, they don’t have to report quarterly on their holdings. That means no one knows what their investments are. 
  • Hedge funds rely heavily on short-term funding through money market instruments. These are normally very safe ways to raise cash, such as money market funds, commercial paper issued by high-credit corporations, and CDs. The hedge funds purchase and resell bundles of these instruments to investors to generate enough cash to keep their margin accounts active. The bundles are derivatives, such as asset-backed commercial paper.
    Usually, this works fine. But during the financial crisis, many investors were so panicked they sold even these safe instruments to buy 100% guaranteed Treasury Bills. As a result, the hedge funds couldn't maintain their margin accounts and were forced to sell securities at bargain-basement prices, thus worsening the stock market crash.  They helped create the September 17, 2008 run on money markets.

Is it right that the financial futures of those relying on regulated advice and regulated funds see their futures messed with in the way that Muddy Waters (not that one) did.

To quote another famous ‘bluesman’, BB King, on this ethically questionable practice 

“You know you done me wrong baby/ And you'll be sorry someday

The thrill is gone

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