The background:

• In September 2005 Porsche bought 20% of its larger but less profitable German rival Volkswagen.
• In March 2007 Porsche bought another 19.9% (to 39.9%) and launched a takeover bid.
• In October 2007 the law preventing the takeover of Volkswagen was scrapped.
• On 20 October 2008 Volkswagen’s share price fell 23% on short selling by global hedge funds who bet the price of Volkswagen was too high and Porsche could not economically acquire more stock.
• On 26 October 2008 Porsche announced it controlled Volkswagen through 42.6% direct holding and call options exercised over the another 32.4% (=75% !). As most of the balance is owned by the state or index funds, that left only about 5% on market to cover the shorts the hedge funds sold.
• On Tuesday 28 October Volkwagen became the biggest company in the world momentarily when the hedge funds had to buy “at any cost” driving the price to €1,005 (from below €200 a year ago)
• Late Tuesday Porsche agreed to release an addition 5% of stock to the market to maintain liquidity
• The hedge funds then complained to the regulators that Porsche built a stake without their knowledge.

The sheer arrogance of Hedge Funds crying foul over this should offend me, but it’s their modus operandi to bully, lie and sneak around to make a buck. They have been accused for years of selling naked shorts. Normally you or I must first borrow the stock we plan to sell short before we are allowed to sell it. We’d pay a fee to the lender of the shares. If you sell without borrowing the shares first you are naked. It’s riskier but often more profitable if you can buy the stock on-market after sentiment has turned against a company. Nothing turns sentiment against a company like a huge overhang of stock on the offer line of the quote screen.

So if you can sell a naked short because you think German Automobile Manufacturers are in for a tough time in this economy, it is in your interests to get that story out after you’ve sold. Short sellers told everyone they could that Lehman Brothers was in trouble after they’d sold.

Now naked short sellers represent a counter-party risk of failure to deliver the stock at Trade plus 3 days (T+3).

Take a look at the failure to deliver reports produced by various exchanges. Some companies are consistently targeted by naked short sellers and the sellers regularly fail to deliver stock without serious penalty.

Finally someone with the clout to take on Hedge Funds called their bluff and made a bundle. So the hedge funds cried to the regulators.

These are the same hedge funds ignoring T+3 delivery dates on equities. Imagine what happens if you or I fail to deliver.

What makes me assert these were naked shorts? If the Volkswagen volume was mainly covered shorts it is unlikely the hedge funds would all need to return their borrowed shares on Tuesday 28 October. The borrowing would all be on a normal distribution. So there would not be a spike on 28 October intraday to €1,005. The price would be elevated but it would shake sellers out to the market.

Similarly any index funds or active investor should have been reweighing their portfolio, so the impact should be relatively minor compared to the recent overall market malaise.

Sadly there is a cost to the punters of this lesson. Most hedge funds do not take retail investments from small investors. Instead our retirement and superannuation funds place some of our pooled funds into them. So a hedge fund’s loss does come home to its small investors.

It still felt good to see hedge funds take a hit.