What’s the problem with Hedge Funds & Mining?
The hedge fund managers like to style themselves as the “smartest guys in the room” but the mining space is littered with examples of hedge funds wandering out of their depth and sinking without trace.
It certainly does not help that mining does not have much of a close genetic relationship with many of the businesses that hedge funds traditionally play in. The problem is that the vast bulk of them don’t know it. In the run-up to 2008 the Supercycle spawned something like a handful of hedge funds that were metals & mining oriented but the debacle of 2008 severely winnowed their number. One London fund, that had become a by-word for “not being able to say no” to any financing, imploded spectacularly. It was no wonder as it reputedly had over 400 positions and the mere task of remembering what one was invested in was a full time job let alone following their activities or financial situation.
In this piece we shall do a review of what hedge funds did in the past and what they might do “this go around”.
ETFs – Sword Juggling for Amateurs
The standard meat and drink of retail mining fans in the ETF space are the GDX and GDXJ as well as the physical gold and silver ETFs. We also have a fondness of our own for the Palladium ETF. However all of this is “too boring” for your average hedgie who is trying to differentiate himself from the hoi polloi.
The latest fad consists of leveraged and inverse exchange traded funds, which are growing in popularity among technical traders who capitalize on short-term moves. The problem is that the stimuli that these traders are used to, such as FOMC minutes, PMI numbers, trade balance and housing starts do not pertain to the gold price. As we have recently noted the gold price has moved rather slightly this while the underlying gold stocks (as manifested in the GDX and GDXJ have moved by a quantum more.
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I am the recipient of an emailed newsletter on ETF trends and I rarely actually read it but a recent edition caught my eye. It dealt with the more exotic ways that hedge fund traders could play the resurgent gold space via ETFs. One was the Direxion Daily Gold Miners Bear 3X Shares (NYSEArca: DUST), which takes the -3x or -300% daily performance of the NYSE Arca Gold Miners Index. This ETF had plunged on the rally in gold miners, the inverse ETF experienced millions of creations as institutional technical traders tried to catch the falling knife, betting on a reversal on the current uptrend. Not unsurprisingly, DUST declined 30.5% in just one month but saw $111.1mn in net inflows, according to ETF.com.
In contrast, the Direxion Daily Gold Miners Bull 3X Shares (NYSEArca: NUGT), the 3x bullish counterpart to DUST, saw $148.9mn in outflows after jumping 20.8% over the same period. One should note though that these might be straddle trades with the same investors on both sides!
The newsletter claimed that tactical bets were being placed on leveraged and inverse gold miner ETFs as investors try to time a bottom or trim holdings once the segment grows long in the tooth.
Traders have reputedly taken an interest in junior gold miners as well. The newsletter cited the Direxion Daily Junior Gold Miners Index Bull 3x Shares (NYSEArca: JNUG), which takes the 3x or 300% daily performance of the Market Vectors Junior Gold Miners Index (our old favorite dog to kick, the GDXJ). This ETF saw $13mn in outflows over the preceding month as the fund surged 47.7% while the Direxion Daily Junior Gold Miners Index Bear 3X Shares (NYSEArca: JDST), the inverse 3x counterpart to JNUG, attracted $29.2mn in inflows in the past month as the ETF plunged 45.2%.
For the more “conservative” there is on offer a range of products that track the miner space with “only” 2x leverage. These include the ProShares Ultra Gold Miners (NYSEArca: GDXX) and ProShares Ultra Junior Miners (NYSEArca: GDJJ) which take the 2x or 200% daily performance of NYSE Arca Gold Miners Index and the GDXJ, respectively.
The double-leveraged inverse versions of GDXX and GDJJ include the ProShares UltraShort Gold Miners (NYSEArca: GDXS) and the ProShares UltraShort Junior Miners (NYSEArca: GDJS). This is how one of the pairs has done in recent times.
If mining space investors did not have enough conspiracy/manipulation theories to deal with already, we recently started to hear complaints about these type of ETFs “spoiling the rally”.
The best example of hedge funds behaving like “babes in the woods” was the adventure of two of the heavyweights of the hedge fund world into the gold exploration space (note: not the mining space and not the gold producer space) back near the height of the gold price. Indeed it may have been their intervention and “blessing” of gold as a mainstream investment that put the icing on the soufflé and led to its collapse. They had both gone from being counter-intuitive in the run-up to the sub-prime bust to the worst kind of me-tooism.
I have not liked Novacorp since I was first introduced to the stock last decade. I was boggled as to a series of properties so inaccessible and with such geographical challenges could be deemed to be attractive. Then when the company becomes a favoured stock of Paulson and George Soros (and this was deemed to be the smart money) we thought the inmates had really taken over the asylum. Paulson was of course still dining out on his perspicacity regarding sub-prime mortgages and could do no wrong. Anyway Paulson had waded into Novacorp around the turn of the decade and had, in 2012, some 36 million shares on which it has lost (according to Bloomberg) around $48mn when Barrick cast doubts on the jointly owned Donlin project. It was probably a pity that Barrick didn’t also cast doubts upon its own Pascua Lama project and would have similarly saved itself a lot of grief. In any case, Novagold (and its similarly challenged doppelganger, Seabridge) have long remained darlings of a certain type of hedge fund that knows little about gold or mining. Fortunately for both the “new chums” have lined up to replace those investors that have preceded them in losing their shirts.
We were never impressed by this intervention. This was just a new version of the fat dumb money that some parts of the mining industry are in permanent pursuit. Indeed it is usually harder to find such fat dumb money than it is to encounter a 10 million oz gold deposit.
Needless to say, since that time, no hedge fund of note has made such a daring intervention in the mining space for fear of suffering the same ignominy.
Here we need to discriminate between funds wanting to improve management and those that merely want to seize control. The classic activist wants to see a change for the better resulting in an enhancement in the stock price and the chance for an exit with a substantial profit. There has been precious little of that in recent years. Looking farther back we can recall attempts to oust the management of Sherritt, but even back in the days of better markets (and more hedge funds) few of the fund managers wanted to get involved in proxy fights to enhance management. This was probably also a product of the sheer lack of hedge funds that could discriminate why current management was not performing to scratch. If you cannot lay out a good argument then one is unlikely to succeed. Combined with this the Canadian corporate scene (in particular) is blighted with a very difficult legal environment for challengers and a rather antipathetic retail base that won’t vote proxies even if they don’t like managements.
Then there is the other type of activism which has been all too common, the board ouster by a group wanting to take control. These have tended not to be run by hedge funds but by some of the same old, same old carpetbaggers of the mining industry. It’s usually, even when the coup succeeds a case of out of the frying pan into the fire for minorities.
Usually this group in the broader markets pick up debt after it has gone sour (or well advanced towards that state) but in the mining world the distressed debt funds have tended to be Vulture Funds in disguise and to the naïve boards run by geologists and their ilk what looks like a guardian angel offering money in the darkest hour just turns out to be a buzzard that will rip their gizzards out, grabbing their project and leaving shareholders with a bankruptcy on their hands. One entity has developed a particular infamy for doing this of late, with Atna being one of the victims. Most miners know who they are now so do not fall for their blandishments. They frankly should be hounded out of the space. Hopefully they will suffer the old Australian curse of “may all their chooks turn to emus and kick their outhouse down”.
Another case that ended more felicitously (I.e. with the fund coming a cropper) was the case of Maudore Minerals. While shareholders lost out (and several of them deserved all that was coming to them) the vulture also had its wings torn off.
We love Short positions. There have not been many opportunities of late with values being so down and out. Shorts are meat and drink to hedge funds though the danger in the space (like ETFs) is that momentum can carry miners in one direction for a long time before gravity (the Wile E. Coyote effect) brings a stock crashing back to earth. One of our favorite shorts of the bull market was US Gold (now restyled as McEwen Mining, la plus ca change). This beast defied all attempts at market discipline as it had a rabid pack of retail followers who not only subscribed to the man but also to the $10,000 gold thesis. It took some gumption to stand up to this raging horde.
Hedge funds can short best when they face up to other institutions on the other side of the trade and there are (in theory, at least) some fundamentals to question. In mining the hedge fund is more often than not on the opposite side from an army of faceless retail investors marching forth with their tin-foil hats as their only battledress.
Hedge funds have a chequered history in the mining space. Instead of being first movers, they seem to be last movers or at least late arrivers. We suspect the mining space scares them, like the old maps used to have something at the edge that said “beyond here, there be dragons”. Liquidity tends to restrict them as they want easy ingress and egress but then they end up playing the industries proxies (Barrick, Goldcorp etc) or the more liquid wannabes (like Novagold, Seabridge) that are ultimately going nowhere. This has repeated the regrettable cycle of larger players funding the “unworthy” and “undeserving”.
Activism has flopped but there is plenty of scope for it. Bad managements have not gone away despite the market attrition. Distressed debt funds will hopefully be rousted from the scene by better financing conditions. ETFs have become more sophisticated than the last time the market was rampant, so we could very well have a situation where they become the “tail that wags the dog” in junior and larger miners. This could produce a divorcing (already maybe being seen) between physical metal movements and that of the underlying stocks in those metals.
The more players in the space the better. This group has largely been absent of late and their return would be a major help for liquidity at the very least and bringing some new mindsets and disciplines to the companies touting their wares.
Christopher Ecclestone is a Principal and mining strategist at Hallgarten & Company in London. Prior to founding Hallgarten & Company in New York in 2003 ... <Read more about Christopher Ecclestone>