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Hedge Funds: The Truth About Flipping

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The conventional view that they're "fast money" isn't always accurate.

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Today's Wall Street Journal perpetuates one of the great myths of today's market.

If you believe Lynn Cowan's piece on the allocations of stock offerings, you go along with the conventional dichotomy: Mutual funds and other established institutions are solid, long-term holders of securities, while hedge funds are scum-sucking flippers just looking to make an easy and quick buck.

Perhaps this is actually true in some cases. I can only talk about my field, convertible bonds. Companies often use convertibles to increase the funds they raise when they do multi-security offerings. They also often issue convertibles as an alternative to a second-round equity offering a year or two or three after going public. So it's worth looking into the behavior of accounts that buy convertibles.

Even with convertibles, the conventional wisdom often persists: The big mutual-fund complexes are the core buy-and-holders, while hedge funds are just looking to flip for a quick profit.

There's only one problem with this conventional wisdom: It's completely false.

Those in the know in the land of convertibles will tell you (especially over a drink), that the most notorious flippers are often the very institutions whose venerable names get them the exalted, though artificial status of "long-term holder" in the eyes of issuing companies. These firms are more than happy to take their quick point or two and move on to the next trade.

Meanwhile, who drives the new issues to the higher valuation that enables the quick profit for the supposedly beneficent mutual funds? You guessed it. The hedge funds are usually buyers, not sellers, of convertibles once they begin trading in the aftermarket. Hedge funds try to unlock the deeper value embedded in the convertibles. In most cases this is best done by owning the bonds over an extended period, adding certain hedges on the underlying stock (and perhaps bonds and options as well) as appropriate.

I remember a number of years ago when Ciena (CIEN) brought a secondary equity deal and a convertible issue to the market. The stock -- being bought exclusively by these so-called long-term holders -- struggled to get above the issue price. The convertible, coming to market at the same time, traded right from 100 to 105. It wasn't the blue-blooded, old-reliable mutual funds driving up the price. No, they were selling to the bottom-fishing hedgers like me. We felt the convertibles, even a quick 5% above the issue price, were a better play than the stock. Since convertible holders got all their money back seven years later, clipping a nice little coupon on the way while equity holders lost more than 90% of their money, we were proven correct.

But the relative merits of convertibles versus stocks, a point on which I speak frequently, isn't the issue here. The issue is that the conventional view of hedge funds as "fast money" versus long-term mutual funds is often, as President Obama might say, a false choice. You need to know how individual institutions operate before you make that call.
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No positions in stocks mentioned.

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