Hedge funds were scrambling to cover their short positions in Volkswagen after shares in Europe’s largest carmaker more than doubled following Porsche’s disclosure that it had increased its stake to almost 75 per cent.
These funds, which aim to profit from share declines by selling shares and buying them back in the market at a lower price, had been betting that the difference between VW’s ordinary shares and its preferred shares would narrow.
Preference shares pay a fixed-rate of interest but do not carry voting rights, while ordinary shares do have voting rights.
At the end of last year, VW’s ordinary shares were trading at €156.10, while its preference shares were trading at €100. The hedge funds bought preference shares and shorted the ordinary shares in the expectation that the spread between the two would close.
“This was meant to be a low-risk trade because the value of the preference shares and the ordinary shares have always been aligned,” one arbitrageur at a London-based hedge fund said.
But the opposite happened. Since the beginning of the year, VW’s ordinary shares have risen by about 230 per cent, valuing the car maker at €157bn ($197bn), while the preference shares have dropped by more than 60 per cent.
The problem for hedge funds was compounded after Porsche said it would lift its stake in VW beyond the level hedge fund managers had expected.
Hedge funds had expected Porsche to increase its holding in VW to just over 50 per cent. But instead, Porsche said over the weekend that it had increased its stake from 42.6 to 74.1 per cent – shocking hedge funds that had made large bets based on their expectations.
VW is a very tightly held stock because, alongside Porsche, the German state of Lower Saxony owns 20.1 per cent, leaving a very small free float of less than 6 per cent. Yet, as of October 23, about 12.9 per cent of VW’s ordinary shares were on loan for short sales – representing the highest proportion for any company on Germany’s 30-member benchmark Dax index.
Worse, index-tracking funds also hold stakes in VW and must retain their holdings so long as VW is a member of the Dax index.
With the short interest now almost twice the free float, it leaves hardly any shares for the hedge funds to buy back and close their positions.
Porsche said that its disclosure was aimed at giving short-sellers a chance to close positions “unhurriedly” following stock moves of the past two months.
But the irony of the statement was that it left hedge funds with no choice but to cover their positions in a panic, particularly at a time when nerves are so fragile.