“Short sales” and other exotics

http://t.money.msn.com/investing/rising-market-slams-short-sellers

Short sales, as this article reveals involves selling borrowed shares hoping to buy them back later at a lower price, creating a profit. The article refers to this as a “bet”. That’s a good characterization of this activity because shorting can be just a gamble. The article reports on a capital management company, “Dialectic” that is a hedge fund. Dialectic holds shares of a company called “Herbalife” whose shares have appreciated significantly this year. In this case, the hedge fund has an opinion about Herbalife’s corporate structure that they believe makes it a perfect stock to short. Herbalife, Dialectic contends is a pyramid scheme. The reader can assume that Dialectic shorted it because if it is a pyramid scheme, it is bound to collapse or be raided by regulators. It hasn’t happened, yet.

I have used hedge funds in my portfolios in the past; selecting portfolios from wealth management companies that hold bond hedge funds. Holding bond hedges makes sense when you are buying bond funds while interest rates are rising. The bond hedge fund will appreciate in value if interest rates continue to rise, while the bond fund will likely depreciate due to the rising rates. Thusly, the bond hedge fund helps to offset the losses in the bond fund. Bond “yields” are  the function of the interest rate or “coupon” of the bond divided by its share price. Prices fall when interest rates are rising because the lower coupon is not in demand against higher coupons available from newer bond issues. That’s why when higher yields are reported, bond investors get nervous. Bond fund managers keep an eye out for inflation or monetary policies that may signal inflation because during inflationary periods, interest rates rise. Most bond fund managers today aren’t seeing indications of inflation.

In my opinion, hedge funds are a “derivative” investment. Derivatives have risk factors that are additional to more straightforward investments. As I have stated elsewhere here, I invest in mutual funds. Sometimes, as I encountered when my portfolios were held at a wealth management company, mutual funds have derivatives in the portfolio; maybe wholly or in part. “Structured” funds are such derivatively-based mutual funds. It is my understanding that “structured” funds may contain securities purchased by the fund with borrowed money or “leveraged”. I have avoided these since I began to manage my own portfolios.

At this time in my practice, I am not holding bond hedge funds in my client portfolios with heavy bond investments. During May, when yields were rising, my bond prices were falling. I used that opportunity to buy more shares of the bonds. The amount I bought was dictated by the relative proportion of the bond holding in the portfolio. I “rebalanced” the portfolio by buying enough shares of the bond to restore its value to the portfolio’s model proportion or its “allocation”.