Last week, the Financial Times reported that some of the world's largest hedge fund managers have experienced painful losses over the past month, prompting many funds to reduce their risk by selling down some of their positions. Which stocks look vulnerable to that process? I name five below and take a deeper look at one -- a stock with a deceptively attractive dividend yield of 18.5%.

5 stocks hedge funds are selling
This table contains five among the top 20 stocks in the Russell 1000 that have suffered the largest absolute declines in hedge fund ownership since the end of March:


Hedge Fund Ownership: Latest vs. March 31

Forward Price-to-Earnings Multiple*

Alpha Natural Resources (NYSE: ANR) 9.6% / 18.0% 9.0
American Capital Agency (Nasdaq: AGNC) 6.8% / 9.4% 1.2
[Price-to-book value]
CIENA (Nasdaq: CIEN) 13.8% / 17.8% 50.2
Novellus Systems (Nasdaq: NVLS) 3.8% / 7.3% 10.8
Family Dollar 15.9% / 24.6% 15.8

Source: Capital IQ a division of Standard & Poor's.*As of July 7, based on next 12 months' forward earnings estimates.

An old classic: Borrow short, lend long
The stock I want to focus on today is American Capital Agency, a mortgage real estate investment trust (I'll refer to the company and its stock by its ticker from now on). American Capital borrows money on a short-term basis and invests in mortgage-backed securities that are guaranteed by the U.S. government or nationalized housing agencies Fannie Mae and Freddie Mac. American Capital faces no credit risk (in theory) and collects the difference between its borrowing cost and the interest it receives on the securities in its portfolio.

(Annaly Capital Management (NYSE: NLY), which is both an 11 O'Clock Stock and a Rising Star pick, is a mortgage REIT with a similar model.)

Lever up!
Sounds like a good business, and American Capital's 18.5% dividend yield must look absolutely irresistible to yield-starved investors right now. Those dividends are supported by high returns on equity (18.4% and 19.6% for the fiscal years 2010 and 2009, respectively.) However, those returns are mainly the product of leverage (currently: 7.4 : 1); unleveraged returns are much less impressive, at 2.3% and 2.9%, respectively.

Not only does American Capital's dividend depend heavily on leverage, but its obligations are for the short term and need to be rolled over continually: Repurchase agreements (or "repos," a form of short-term financing) represent three-quarters of AGNC's balance sheet. Compare that with the way Warren Buffett conducts his affairs at the head of his financial-industrial conglomerate, Berkshire Hathaway (NYSE: BRK-B). In his 2009 chairman's letter, he wrote:

We will never become dependent on the kindness of strangers. Too-big-to-fail is not a fallback position at Berkshire. Instead, we will always arrange our affairs so that any requirements for cash we may conceivably have will be dwarfed by our own liquidity. Moreover, that liquidity will be constantly refreshed by a gusher of earnings from our many and diverse businesses.

Financially dependent
Contrary to Berkshire's modus operandi, American Capital depends very much on "the kindness of strangers," and it's impossible for the company to strengthen its capital position by retaining earnings. As a REIT, it is required by law to distribute 90% of its taxable net income annually.

Despite this, two exceptional hedge fund managers, Balestra Capital and Whitebox Advisors, were among the top hedge fund owners of American Capital shares as of the end of the first quarter (Balestra was also Annaly's largest hedge fund investor). Unless you follow the hedge fund industry relatively closely, you won't have heard of them; however, I can assure you they are the real deal (both anticipated the subprime crisis, for example). It will be interesting to see whether they were among the funds that reduced their exposure to American Capital during the second quarter.

The dividends aren't free money
Barring a substantial mispricing, the market is not gifting investors a better-than-15% equity premium over the 10-year Treasury yield without risk, and there is no reason whatsoever to believe American Capital's shares are substantially undervalued. They may have been in March 2009 but have doubled since then.

Investors should be aware that American Capital (and Annaly) are exactly the sort of stocks that could inflict maximum pain on shareholders if the U.S. fails to extend its debt ceiling in time and enters into technical default -- or if the credit markets were seize up for any reason. To get an idea of the kind of losses I'm talking about, one needs to only look at shares of American Capital's external manager, American Capital Strategies (NYSE: ACAS), which lost 99% of their value between January 2007 and March 2009 (today, that loss is only three-quarters).

Crisis -- what crisis?
Not to worry, though, "in the absence of another crisis, you'll do well," as PIMCO's Bill Gross assured investors in recommending Annaly in Barron's January Roundtable. Another crisis? It hardly bears mentioning, surely.

If you're looking for low-risk dividend stocks, The Motley Fool has identified 13 high-yielding stocks to buy today.