George Soros recently took a large stake in Herbalife (NYSE:HLF), the same company hedge fund giants Bill Ackman, Carl Icahn, and Dan Loeb have been fighting over for most of the past year. The tiff between the men highlights how much of a game hedge fund investing can be. It's not about long-term investing like we promote here at The Motley Fool; it's about short-term profits and bashing the competition whenever possible.
Hedge funds have at times become more focused on this game that they are on investing. And believe me, this isn't a game you or I can play.
The art of the short squeeze
Shorting a stock is one of the few ways to make a profit when a stock goes down, but it's also a dangerous way to bet, because your downside potential is limitless, which is why hedge funds target short-sellers like Ackman.
I first learned of the power of the short squeeze in hedge funds from Jim Cramer's Confessions of a Street Addict, which came out in 2002 before dozens of hedge fund managers became household names. Cramer wasn't always the boisterous TV personality he is today; he was once a respected, albeit volatile, hedge fund manager with a long track record of solid returns.
What a lot of people outside Wall Street don't understand is how small the inner circle is there. Ackman and Icahn have had dealings in the past, Loeb was once friends with Ackman, and lots of smaller funds run with the same crowd. That's why it's easy to learn when someone is building a big short position and when other managers may be able to implement a short squeeze. In Ackman's case, it would go something like this:
Ackman has made a $1 billion bet against Herbalife, which would be difficult to liquidate, given its sheer size. If other managers buy up large stakes and go on talk shows touting the stock, and the market pushes it higher in response, Ackman could be sitting on a big loss. Even a 100% loss on the short position may not be devastating to his $12 billion hedge fund Pershing Square Capital, but if he has a few redemptions or a few other bets go the wrong way, it could force Ackman to liquidate, causing a short squeeze. That's when other managers see blood in the water, and whether they like a company or not, the mechanics of the market can push a stock higher -- fast.
Just look at Tesla Motors' (NASDAQ:TSLA) meteoric rise over the past three months. When Tesla reported earnings last, there were 116 million shares outstanding, and about 26% of those shares were sold short. When the stock began to rise, many investors panicked and closed out short positions, fueling the rise over the next few weeks. Since then, 12 million fewer shares are short, and the short squeeze was a huge winner for those who could ride it.
The short squeeze is just one of the games hedge funds play that most investors can't. David Einhorn has become masterful at using speaking engagements at investing conferences to tout his positions, usually resulting in a herd mentality to follow him. Others will go on CNBC or contact newspapers to spread rumors that may or may not be true. Then there's insider trading that Steve Cohen's SAC Capital is currently dealing with.
These aren't games most people can play, and they highlight what a different world hedge funds live in. Most aren't in a stock for the long-term; they simply see an opportunity they can exploit and will do so as long as it's legal or they can avoid getting caught. That's why following a big name can be dangerous, because by the time you know what they're doing, they've already won and may be taking the opposite side of the very trade you're making to follow them.
Long-term investing wins
The average investor can't wage a proxy war like Carl Icahn, short a stock like Bill Ackman, or bring a company to its knees like David Einhorn, and we really shouldn't try. Foolish investors know that long-term investing is about finding great companies and holding them for a long time.
There's also no guarantee that playing games like big hedge-fund managers do will work. David Einhorn returned just 8.3% last year, Ackman returned 12.4%, and John Paulson's famous gold fund is down 65% so far this year. Meanwhile, the Dow Jones Industrial Average's (DJINDICES:^DJI) total return for 2012 was 8.6%, the S&P 500's (SNPINDEX:^GSPC) was 14.2%, and the two are up 20.9% and 20.6%, respectively, so far this year.
Fool contributor Travis Hoium has no position in any stocks mentioned. The Motley Fool recommends Tesla Motors . The Motley Fool owns shares of Tesla Motors and has the following options: long January 2014 $50 calls on Herbalife. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.