Managing Liability Affects Stocks, Pt. 1

Every investment has to be funded by some set of sources. Many investment vehicles, such as defined benefit pension plans and IRAs, have purposes for which they must disburse cash at some point in the future. How investments are funded and the time period over which the assets will have to be liquidated for the good of beneficial owners are factors that drive the portfolio-management methods of a large number of investors.

Strong Hands vs. Weak Hands

When I read books on speculation from the early 20th century, I run across language describing the ownership of a stock being in "strong hands" or "weak hands." That language is still sometimes used today, though not as much. How can the hands holding a stock be strong or weak?

First, it's important to understand that at every moment in time, every financial asset is owned by some person or institution. If someone is short a stock, an equivalent long position is created synthetically by the borrowing from one investor and selling to another. No net new assets are created.

Buying an option is similar; the market maker either finds another investor who wants to sell the option, or he sells the option himself. No net option exposure is created in the market. The option is a side bet in a much larger market for the underlying equity.

Here's a simple example: A cash buyer of a stock is a stronger holder than one who buys on leverage. The leveraged holder can be compelled to sell in a declining market. The cash buyer can hold forever, in principle. Similarly, a cash buyer of a stock is a stronger holder than one who sells short. The short can be forced to cover if the price rises enough, or if she must buy his position back because the stock she borrowed isn't available anymore and no additional stock is available to borrow.

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David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. At time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to [e-mail].