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Hedge funds caught in short squeeze

Bloomberg News

LONDON -- Hedge funds may post their worst month in at least five years after bets on financial stocks falling and on crude oil rising backfired.

Hedge Fund Research Inc.'s Global Hedge Fund Index of more than 55 funds slid 3.2 per cent through July 24, heading for the biggest monthly drop since the measure started in 2003.

Wagers on a drop in financial stocks and home builders soured after shares of U.S. mortgage lenders Fannie Mae and Freddie Mac more than doubled during the six trading days to July 23.

Bullish bets on crude oil turned to a loss as oil slid 15 per cent from a record $145.29 (U.S.) a barrel on July 3 after doubling in a year.

Short selling of Fannie Mae and Freddie Mac jumped in the first two weeks of July as the stocks fell on concern that shareholders would be wiped out even if the government bailed out the entities. Instead, the shares doubled over six trading days, catching out investors who shorted the stock - borrowing shares in anticipation of buying them back at a cheaper price.

"Everything that went up was the most shorted," said Christopher Watling, head of London research firm Longview Economics. "It was a classic short squeeze ... not buying because fundamentals had changed. It was a true sucker's rally."

Some of the most-shorted European stocks, mortgage lenders and home builders in Britain, also soared. HBOS PLC, Britain's biggest mortgage lender, climbed 17 per cent on July 23, the most in six years, amid speculation it could be purchased. Home builder Barratt Developments PLC more than doubled in three weeks, while rival Taylor Wimpey PLC almost doubled in 11 trading days.

"There's little doubt it was difficult," said Simon Cawkwell, a former accountant and investor who wrote Evil's Good, a guide to short-selling. "The banks soared, all the associated stocks and the home builders. It caught a lot of people out. It caught me out."

Another popular trade that backfired was shorting German car maker Volkswagen AG while buying its preferred shares. Many hedge funds and Wall Street proprietary trading desks bet that the difference between the two would narrow as investors realized the voting rights may not be worth a premium. Instead, the difference between the shares widened to the most in 15 years.

Still, Mr. Cawkwell, who has traded for more than four decades, said last week's reversals were "par for the course."

The gains that will be made after British stocks hit a bottom, which are still "far off," may be treacherous for short investors, as they were in early 1975, he said.

"Some of these stocks will advance very sharply indeed. In a week one could see 100-per-cent advances," Mr. Cawkwell said. "This can happen, I promise you it can. Suddenly the whole thing turns around."

© 2007 The Globe and Mail. All rights reserved.

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