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Hedge Fund Report: Seeking a Few Winning Trades

With the fourth quarter a month old, 2005 is shaping up as a brutal year for hedge funds. Anyone perusing the business press over the weekend saw a slew of stories highlighting the problem.

A lot of funds still are in desperate need of a big trade or two to achieve the kind of returns their clients have historically demanded. Until now, a major problem had been a lack of volatility in the stock and bond markets, but that trend looked to be ending finally with the wild action of the last two weeks.

Still, many strategies continue to struggle. Among the laggards, according to fund-of-funds managers who spoke to, is the equity long/short category, an established, well-understood and nonesoteric strategy. Because it's popular, a bad idea in this space can hurt a lot of bottom lines. One example has been a propensity among managers to buy energy shares while going short retail. That approach has been a loser as crude prices have declined.

Another dangerous sector has been merger arbitrage. "People are getting killed. Too many deals get busted," complains an investor. Last week's example was School Specialty (SCHS), a Wisconsin-based provider of education services and tools. Last Tuesday, Bain Capital announced that it was canceling a plan to buy the company. The following day, the stock fell by 9% to $34.11; it was trading for $33.75 on Monday morning. Obviously, merger arbitragers who were long the stock got hurt.

Other high-profile blowups in the space have pushed some arbitragers into the realm of shareholder activism. One that has adopted the activist toolkit is Paulson & Co. Last week, the New York hedge fund, which owns 19% of Canadian steelmaker Algoma Steel, demanded a recapitalization of the company and called for a special shareholders' meeting before year-end to replace a majority of the directors. The Ontario-based company has rejected Paulson's demands, saying its decision to pay a special dividend instead was the prudent move during an "uncertain time in the steel industry's cycle."

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