The following is a guest post from Eric Fernandez, CFA of Two Rivers Analytics.
The S&P is at record highs yet again. Shorting has been difficult for the past several years as equities have continued their ascent. More than a handful of well-regarded short-biased funds have closed their doors since 2014. You could be forgiven for asking what shorting is good for.
Don’t short-change shorting
The top three reasons institutions invest in hedge funds, according to Prequin’s Global Hedge Fund Report, are:
- to seek uncorrelated returns (59%);
- to seek higher risk-adjusted returns (56%); and
- to reduce portfolio volatility (46%).
Surprisingly, just seven percent (7%) of investors are looking for the highest returns.
Yet, in a counter-intuitive outcome, shorting adds value even when it produces negative stand-alone returns. Why? Because shorting makes the most money when markets decline. Reducing losses in a downdraft preserves more capital to take advantage of subsequent bull periods. An allocation to shorting helps longs survive the downturns and thrive on the recoveries.
Of course, we short to make money, not just to reduce volatility. We and several of our research competitors generate positive, stand-alone short returns.
Pressures on hedge funds
Sixty-six percent (66%) of investors say that finding good funds and subpar performance are the largest impediments to hedge fund allocation. Fees have come down over recent years and the traditional two-and-twenty model remains under severe pressure. There are many ways to differentiate a hedge fund. Being able to demonstrate high short attribution is one of the most effective ways because it is still rare.
The risk-return profiles of various hedge fund strategies shows that a typical long/short fund has the highest volatility. Long/short volatility is higher than in event-driven, multi-strategy, macro or relative value strategies. While reducing volatility could simply be a matter of reducing beta by retaining higher cash balances or selling indices short, investors notice when funds take the easy way out.
Investors are increasingly reluctant to open their wallets for funds merely riding beta. Decreasing net exposure with more single stock shorting will lower volatility and maximize risk-adjusted returns. We contend that long-term survival in the hedge fund world depends on producing alpha on the short and on the long side.
Constraints to Hedge fund Shorting
Our clients face the recurring problem that they spend the bulk of their time looking for good long investments, leaving little time for alpha shorting. Often they have no process for identifying short candidates and find themselves in the short equivalent of “hedge fund hotels” such as Cheniere in 2014 or Valiant last year.
“Fake shorting”, as we call it, with indices and/or ETF’s doesn’t optimize short exposure because it does not take advantage of idiosyncratic opportunities. This fake shorting is a trouble spot with investors who recognize that hedge funds should actually be shorting. Anecdotal evidence tells us that fee pressures are more pronounced when short-cuts like index shorting are used. We believe that alpha shorting and producing meaningful return attribution from the single-stock shorts will be critical in maintaining a differentiated strategy in the increasingly concentrated hedge fund world.
Idiosyncrasies of shorting
That said, what are some of the uniqueness to shorting when compared to investing long? Some of the key elements that we see repeatedly are buy-out risk, valuation being less useful, costs to borrow, different time horizons, the greater importance of an investment catalyst and the importance of risk cycles.
In turn, valuation, in long side investing, is often assumed to act as a lower bound on long risk. We have all seen the research that “cheap beats expensive”. On the short side, however , the valuation boundary is much fuzzier. As Keynes once said, “the market can stay irrational longer than you can stay solvent”. This is of course, true. Short sellers are living through a time right now when the most expensive stocks continue to rally the most. Valuation is an important contributor to short returns, but it always needs to be accompanied by identifiable downside catalysts.
Our short models contain meaningful weights for valuation but we would never short a stock based solely on valuation. What valuation does provide for short sellers is an amplification of the downside when a company breaks fundamentally or investors reassess a stock’s prospects. The classic example was outlined by the late Professor Haugen who coined the term “torpedo stock”. Torpedo stocks were those stocks that play the “beat and raise” game well. Investors came to expect that consistency, which became embedded in the valuation. However trees don’t grow to the sky. These stocks often get bid up far in excess of their fundamental prospects resulting in extreme overvalued situations. The short analyst will focus on expensive stocks that fit this description and show signs of troubles such as new competition, pricing pressure, declining margins, slowing working capital or earnings manipulation. These create favorable shorting situations because stocks that trade at seven times sales which may be cut to four times sales when the fundamental problems are recognized by the market.
Buy out risk is another unpleasant quirk on the short side. The same exuberance that can be seen in valuation can be seen in the M&A world. The situations to watch most closely are those where there are large players in a maturing industry and many small players. Those larger players will often seek to boost growth with the acquisition of smaller niche companies. The risk is greater in certain industries such as pharmaceuticals, medical devices, emerging technology, and in consumer brands. Acquisition risk is always present in short investing. Other than avoiding dangerous situations entirely, defenses against acquisition risk include position sizing and constantly evaluation of one’s short thesis for an early exit.
Another peculiarity of shorting are the stock loan or borrowing costs. For difficult to locate stocks, the borrowing costs can be excessive. For instance, the borrow on SolarCity stock had reached 60% to 70% prior to the Tesla offer. Unless one was sure that SolarCity would go bankrupt very quickly, one would be very reluctant to assume those carrying costs.
Time horizons are frequently compressed on the short side. A tightly defined time frame for a short investment offers some protection against buyout risk and mitigates borrowing costs. Accordingly, for these and other reasons, we spend a lot of our time looking for short catalysts. These are concrete reasons why a short position in a stock will “work” in the near-term. Examples might include the introduction of a significant new competitive product, expected unwinding of unusual inventory build-up, declining product prices or upcoming debt maturities.
Finally, short stocks sometimes suffer sharp rallies when investors are feeling very