Monday, September 9, 2013

When Being Correct Isn’t Enough: Hedge Funds Lose on Nokia Deal

When Being Correct Isn’t Enough:  Hedge Funds Lose on Nokia Deal

In 2007 Nokia’s stock peaked at about $40 per share as it dominated the market for cellular handsets.  However, within a little more than a year the stock was under $10 per share and had become a reliable short position for many hedge fund managers. As the company’s fundamentals continued to deteriorate and Nokia lost more and more market share to Apple, Samsung, and other smart phone companies, there was little to suggest that Nokia’s stock would rebound.    As a result, a variety of hedge fund managers were short the stock when Microsoft announced they were acquiring Nokia’s handset business.  As Nokia’s stock rebounded on this news, those hedge funds suffered significant losses.[1]

Some of you may not be familiar with shorting, so here’s a quick primer.  An investor (for purposes of clarity, we’ll assume it's a hedge fund) is short a stock when they sell a security they do not yet own.  The hedge fund is betting that the stock will fall in price, and they’ll eventually be able to buy it at a lower price.  In order to deliver the stock to the buyer, the hedge fund borrows shares from another investor.  This means that the short seller has to pay interest to borrow the stock and pay any dividends to the investor who loaned the stock.  The hedge fund also has to deposit cash and securities, known as margin, representing 30% of the value of the trade. 
The Big Announcement (2009)
If the stock were to fall to zero, the hedge fund would double its money, less financing expenses.  Since there’s no limit on how high the stock could rise, in theory, the investor could lose an infinite amount of money by being short.   In reality, a hedge fund facing a rising stock price would attempt to cover the short before it had lost all of its investment and would feel enormous pressure to do so, because the margin requirement would escalate as the stock appreciated.

Two major categories of hedge funds might have been short Nokia.  One group, known as short-biased hedge funds, manages a portfolio full of short positions.  This type of hedge fund makes a one way bet that its holdings will go down in price.  This strategy is extraordinarily challenging to execute since markets tend to rise over time, and the financing costs of maintaining a short portfolio are high.

Equity long-short managers represent a large proportion of all hedge funds.  As the name implies, these managers construct portfolios of stocks they own and those that they are short.  To varying degrees, these types of managers can control their exposure to the overall market or an industry since their long and short positions tend to offset one another. The idea is to profit from picking enough good stocks and shorting enough bad stocks while muting out other factors such as the volatility of the market.[2]

In the case of Nokia, I’m pretty confident that the short-biased hedge funds simply saw a weak company that was only expected to get weaker.  In the case of diversified equity long short managers, I suspect the short in Nokia was probably hedged with long positions in strong telecommunications or perhaps Finnish companies.  In either event Microsoft’s announcement caused Nokia’s stock to rise, leading to losses for those short the stock.  The losses were probably magnified because a large number of hedge funds needed to quickly cover their short position in Nokia when the deal was announced.

The Microsoft-Nokia deal demonstrates why hedge fund managers might be tempted to seek out inside information.  While detailed fundamental research was capable of producing a solid case against Nokia, the prospect of an investment banking transaction was not discernible by legal means.  The Microsoft offer to buy Nokia’s mobile business came out of the blue and led to pain for those short the stock.  The deal also illustrated that sometimes being right about the fundamental prospects of company isn’t enough.  Sudden external events, like a deal, can blow up otherwise well crafted strategies.

[2] A significant subset of equity long-short managers employ leverage.  In other words, they borrow funds to supplement their equity.  By leveraging, the manager can build a much large portfolio than a manager not employing leverage.  Obviously, the risks and rewards are magnified.

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