Successful short selling – an effective but rare skill

Financial Times

Nervous investors are constantly looking for ways to protect their portfolios as economic uncertainty persists. With “risk-free” yields at historic lows, some are examining the case for short bias funds – investments that are net short – as a hedge against downswings. “The majority of the time markets rise so a short strategy is likely to lose money,” says Robert Marquardt, founder of Signet, a $1.5bn fund of hedge funds firm. “But in a highly indebted environment with potentially no growth for five years there could be a re-rating downward of stocks just as there was a re-rating upwards in the 1980s and 1990s. The changing dynamic could bring short bias back in vogue.”

Returns from short bias funds over the past few years do not make particularly happy reading as shorting only works in particularly dire years. In 2008, for instance, the strategy returned 28 per cent to investors, according to HFR. But it lost investors 24 per cent in 2009 and 18 per cent in 2010, compared with 10 per cent gains for the average hedge fund investor.

It is little wonder that, despite the common perception that hedge funds are obsessed with shorting, in reality there are few specialists on the short side. Jim Chanos, a veteran hedge fund manager and founder of Kynikos Associates, is one of a tiny number to have outlasted a single economic cycle.

Alain De Coster, a co-founder of ABS Investment Management, a $3.7bn fund of hedge funds firm based in Greenwich, Connecticut, says his firm does not invest in underlying managers that are pure short sellers. But ABS likes to invest in managers that have strong skills on the short side as well as the long side as part of the portfolio mix. “In bull markets the short trades may lose money – although they are often linked to company-specific rather than market news – but the long trades are going to make a lot of money,” Mr De Coster says. In other words, even though short sellers tend to lose money more years than they make it, they are included in portfolios as insurance.

One of the reasons that short bias funds frequently underperform is that the technique is complex and managers do not always have the requisite skills. Most managers come from prop desks and have plenty of experience in long-only investing but are weaker in their short books. Good shorting skills are a rarity, says Mr De Coster.

Short selling is also an inherently complex strategy. First, losses from the strategy are potentially unlimited while gains are limited to a stock falling to zero. Short sellers also face short squeezes, when a stock suddenly rises for some reason and investors rush to cover their positions to limit losses.

The ability to time markets is not a gift given to many, but for a short seller to make positive returns, the timing has to be just about perfect. “They have all the same problems of timing as dedicated long-only investors – only worse because falling markets tend to be more volatile,” says Mr Marquardt.

“If stocks rise they tend to cut their losses for risk management reasons at the wrong time, just before the trade turns in their favour. You could have made money last fall if you were short but it is often dangerous to be short when stocks have already fallen a long way.

“To maximise profits shorting you need to get in when skies are blue, but then you need the storm clouds to arrive fairly quickly after. It’s not easy.”

The spate of short-selling bans around the globe is further blighting the strategy. In June 2010, Germany permanently banned naked short selling (where a trader sells a stock without borrowing it first, risking being unable to complete the trade), while last summer France, Italy, Spain, Belgium and South Korea banned short selling in their financial stocks.

Of course, restrictions on short selling are not new. The US introduced the so-called uptick rule in 1938, which effectively prevented traders from making a short sale unless the price of a stock in its most recent trade had been up from previous levels. The rule was removed in 2007, and the debate is ongoing on whether to reinstate it. It is reasonable to assume that if economic conditions worsen, the environment for short sellers may get tougher.

Despite the difficulties, many funds of hedge funds do employ funds that either have a permanent short bias or are mandated to go net short from time to time. “We made money in the financial crisis by being short selected stocks such as monoline insurance companies and banks and let our shorts run through 2008,” says Mr Marquardt.

“You then have to be pretty nimble to reverse your positions and avoid giving up all your gains if the market turns as it did in 2009. The problem for hedge funds was not all about 2008: quite a few long/short funds blew up in 2009 because they were too slow to change tack.”

Despite continuing eurozone fears, he believes heavy shorting could be dangerous this year. A risk rally is quite possible. Even during the worst of the 2008 financial crisis and the 2011 eurozone crisis, few long/short funds were outright short and with some justification: despite the perception that 2011 was a terrible year, many equity investors were not badly hurt – the S&P 500 finished the year close to where it started.

For this reason, Signet prefers variable bias funds that have the capability to react to any prevailing environment.

As Mr Marquardt says: “We seek underlying managers who are confident about being net long, net short or neutral. That is strategically desirable, but they are hard to find.”

This is part of a monthly series on hedge fund strategies

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