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Scott Reardon has a background in special situations, deep value strategies and activist investing. Prior to co-founding Dakon Capital, he was an analyst and the director of corporate development at a holding company pursuing a Berkshire/Leucadia strategy. Previously he was a research fellow at... More
  • Oops Your Short Strategy Just Died 0 comments
    Dec 13, 2013 12:29 PM

    If you've been reading the financial press, it seems like everyone and their mother is launching a long-only hedge fund. According to the journalists, this is in response to the recent bull market. Shorts have gotten hammered. Long has been the way to go. Therefore fund managers, in true rearview mirror thinking, have decided to drop their short strategy and focus on the long side.

    This analysis ignores a far bigger truth, however. The hedge fund model is a silly model for the vast, vast majority of investors.

    The problem doesn't come from the long side but from the short. Shorting stocks is generally a terrible way to make money, a terrible way to hedge and a terrible way to grow your long-term wealth. And due to ZIRP and quantitative easing, it's only gotten worse.

    This is a paradigm shift. The hedge fund world changed in 2009, and no one is talking about it.

    Shorting doesn't really make money, and it's going to make even less in the future

    You might be wondering: "If shorting is so bad, how come so many hedge fund managers have made so much money doing it?"

    The short answer is: they haven't.

    Shorting is a great way to get attention for your fund, but there's a reason why no one talks about how much alpha he's generated on his shorts. Not very many people really do. In fact I suspect even hedge fund managers known for their short calls haven't actually generated much return on their short books in total.

    It's hard to get good data on this because few hedge funds disclose how much they've made on their shorts versus their longs. But I think looking at the returns from 1995-2010 of Lee Ainslie's Maverick Capital are instructive.

    The Maverick Fund, the main fund, which is long-short, returned 14.1% a year on average after fees. Maverick Long, the long-only fund which holds the same long positions as the main fund, returned 13.6% a year on average after fees.

    (click to enlarge)

    Source: Market Folly, Maverick Capital.

    These are fabulous returns, which is why Ainslie is a billionaire, but what's interesting is they're practically the exact same.

    And when you account for different fee structures and the fact the main fund uses leverage and the long-only one doesn't seem to, I'll bet you these returns remain practically the same. So essentially the short book contributed nothing to the long-term returns of the main fund. This is hardly the "double alpha" hedge fund investors think they're getting.

    But here's the scary part. Maverick's short book and everyone else's benefited hugely from something that doesn't exist anymore: the short rebate. Before ZIRP and quantitative easing, shorting stocks got you an additional 5% of return due to the short rebate. Think about that. The mere act of shorting once gave you 5% of "automatic alpha."

    Here's how. When you short a stock, you get paid a cut of the interest paid on cash proceeds from the sale. The diagram below illustrates where the money goes in a short sale.

    (click to enlarge)

    Source: Interactive Brokers.

    The short seller is the borrower here. As you can see, he pays a fee to borrow the shares. Provided the stock isn't a hard-to-borrow security, this is typically a small fee. He borrows the shares, sells them, then posts the cash proceeds from the sale as collateral with the lender.

    It used to be the borrow fee was small. However, brokers increasingly view securities lending as a source of profit and have started to categorize more and more shares as "hard-to-borrow." This means the borrow cost could be 4% a year or it could be as high as 90% a year, as was the case with Groupon. Other famous examples:

    Facebook: 40%

    Krispy Kreme: 50%

    Tesla: 50%

    These are obviously extreme cases, but here's the point: it isn't enough for the short seller to be right about a stock. Everyone else can't be right too.

    The most pervasive problem though has to do with the short rebate, which is something the short seller doesn't pay but receive. The cash proceeds from the short sale get posted as collateral with the lender, and the borrower is entitled to a large cut of the interest generated on it. Usually he gets interest payments equal to the federal funds rate minus 50-100 bps.

    But here's the issue: there is no federal funds rate anymore. The Federal Reserve sent it to the glue factory in 2009.

    (click to enlarge)

    Source: Federal Reserve.

    Up until 2009, you earned a nice return just to short a stock.

    There are reports of a monkey escaping from the Bronx Zoo in 2006 and stealing a laptop with someone's Fidelity account open on it. The monkey began furiously mashing the keys on the device, thereby placing an order shorting the stock of American Airlines. The stock stayed flat, but the monkey made 5% simply by virtue of placing the trade. After his hedge fund blew up in 2009, "Mr. Peepers" currently works in risk management at a bulge bracket firm.

    In the 90s and mid-00s, you got paid 5% just to bet against a company. This was a lollipop in the mouth of hedge funds, and the Fed has ripped it out. Now instead of getting paid to short, most short sellers must pay for the privilege.

    Make no mistake: this is a paradigm shift. The difference between getting paid 5% to short and having to pay 4% makes all the difference in the world. I am concerned both Mr. Peepers and today's short seller are at risk of being put back in their cages.

    Shorting doesn't really reduce risk. You've only been told it does.

    Shorting is supposed to reduce market risk. A quick example shows why.

    Say a manager puts 100% of the money under his care into stocks. He is 100% long and therefore except to the degree his holdings differ from broader market, he is completely unhedged to market risk.

    Now let's say he shorts a number of other stocks such that 50% of his portfolio is now short. Keep in mind he hasn't sold a single long position. He has simply shorted enough other stocks so that 50% of the money under his care is short. 100% long minus 50% short equals 50% net long. Thus at least in theory he is 50% exposed to market risk and 50% hedged against it.

    Now let's say another 2008 happens, and the market plummets. While everyone else suffers, say, a 40% loss, our manager will lose only 20%. That is because the gains from his shorts offset the losses from his longs. You can see how long-short has great appeal. It protects you at the exact moment you need it.

    The only problem is it also protects you--disastrously--when you don't need it.

    Yes in 2008 a long-short strategy would have served you well, and yes hedge funds did what they were supposed to that year. According to the HFN Hedge Fund Aggregate Index, their drawdowns on average were 15% compared to the market's 40%. (Note these figures do not account for massive survivorship bias.) But that's only 2008. If we move back in time to 1999, you see almost the mirror opposite.

    Shorting would have nearly bankrupted you that year.

    Wes Gray from Empiritrage has an interesting backtest on this. He took Joe Greenblatt's Magic Formula and another similar strategy called Profit + Value and backtested them as long-short strategies. Essentially you go long the best stocks according to each formula and short the worst.

    The Magic Formula buys stocks according to cheapness (EV/EBIT) and quality (return on invested capital). Shorting would be the opposite of that, so you'd short stocks that were expensive and had low returns on capital. These are of course the exact type of stocks short sellers look for.

    Profit + Value does the same thing except it uses Price-to-Book and Gross Profit/Total Assets as its value and quality measures.

    The chart below shows the drawdowns of each long-short system during the internet bubble. Note the percentages refer to market cap rank of the stocks included. For example, "20 perc" means the stocks were those larger than the smallest 20% on the NYSE.

    (click to enlarge)

    Source: Wes Gray, Empirical Finance.

    As you can see during the Nasdaq run-up in 1999, you would have received a punch to the soul if you'd run one of these long-short systems. All of them suffered heavy drawdowns, particularly Profit + Value, which was down a staggering 83%.

    Ask yourself something. In 2008 hedge funds were down only 15% on average versus 40% for the market. That's 25% of alpha. Is it worth getting 25% of alpha in 2008 if it means you lose 83% of your portfolio in 1999-2000?

    Keep in mind during that period the Nasdaq was up 130%. Also due to the death spiral of reverse compounding, if you lost 83%, you would now have to make almost 6 times your money just to get back to even.

    Of course that 83% includes some smaller companies on the NYSE. But even looking at Profit + Value and the Magic Formula as applied to larger companies, you continue to see horrendous results. The Magic Formula would have been down 47% and Profit + Value 41%. And they would have been down during a time when the market was up.

    If career risk is what attracts you to long-short strategies, ask yourself how likely it is you would keep your job if you were down 83%--or even "just" 41%--at a time when your benchmark was well up in positive territory.

    This is the fundamental problem with long-short strategies: yes they protect you when you need it, but they can protect you to death when you don't.

    It reminds me of a scene in Robocop where the executives of OCP unveil Robocop's replacement, a massive robot designed for "urban pacification" called Ed-209. To illustrate Ed-209's prowess, one of the executives is given a gun and told to point it at Ed-209.

    Ed-209 immediately powers to life and growls for him to drop the weapon. He does so, but Ed-209 in an apparent long-short strategy malfunction continues ordering him to drop the weapon. At this point the executives are running for cover. The scientists are trying to turn the robot off. But they can't. I'll spare you the gory details, but in the words of the CEO to Ed-209's creator afterward: "Dick…I'mvery disappointed."

    Unless you're a brilliant market timer (which you're not), long-short systems can be a cure worse than the disease. This is why many famous investors like Li Lu stopped shorting stocks after suffering heavy losses. In a bubble, even if you're right, you're dead.

    High Conviction Shorts

    Actually there doesn't even need to be a broad stock market bubble to take the shorts out feet first. Earlier when we looked at Wes Gray's backtesting, we were looking at the systemic market risks of running a long-short system. But what about the idiosyncratic risk of one particular high-conviction short position?

    Let's say your hedge fund manager like so many others develops conviction around his Tesla Motors short. Instead of running an equal-weight system like Gray was doing, he commits 5-20% of the fund to position. Maybe he's ultimately right that Tesla is not a billion-dollar company. But with shorting, that just isn't good enough. You need to be right and you need to be in at the right time.

    In the case of Tesla, which huge numbers of fund managers have shorted, it costs 50% a year to hold the position. And what would your manager get for paying so much? Tesla is up 300% since April 2013. If you look at the popular short ideas on places like Sum Zero, you see these kinds of disasters on the short side all the time.

    Shorting can sneak in leverage

    Imagine your manager does what many other "hedged" funds do and levers his longs and shorts at the same time. This would involve for example going 300% long and 250% short. Thus the manager is still "only" 50% net long even though he's highly leveraged. He's taking less risk than all those long-only hillbillies, right?

    Wrong.

    With this kind of leverage, if the stocks in the short book go up just 40%, the entire portfolio blows up. All your equity will have been wiped out, and the manager's account will be closed.

    I'm not saying don't use leverage. Every time someone lectures someone else about the evils of leverage, an angel in Blackstone's executive suite gets his wings. But I think you'll agree this is a huge amount of risk for a little return.

    Shorting crowds out time spent on longs

    Another reason to hate shorting: the time it takes.

    I've polled a lot of friends and acquaintances who run short books and asked them how much time they devote to shorts versus longs. I have yet to find a single person who spends less than two-thirds of his time on his shorts. It seems to be a gigantic time suck. And yet these same people tell me they generate tiny returns if any on their short books.

    So shorting (NYSE:A) doesn't generate much alpha, (NYSE:B) trades drawdown risk for outright blow-up risk, (NYSE:C) allows your manager to sneak in leverage and (NYSE:D) distracts your manager from the part of the portfolio that actually makes money. My goodness, what else does shorting do? Drown kittens?

    Has it ever struck a child in anger? This is just more terrible on top of terrible.

    Conclusion

    It brings me no joy to write these things about shorting, especially at a time when the market is so richly valued. Shorting is important to the functioning of markets, and besides it's a heck of a lot of fun. In a world that tells you to be "positive" all the time, it's wonderful for us buyside shut-in types to get to be negative--and right.

    There will always be a small number of people who are consistently great at shorting. I'm just not sure I would bother trying to find them.

    Even though shorting has never been easy, it has gone from a positive-sum game to a negative-sum one. And that means shorting has changed from something where everything's okay as long as you're not totally wrong to something where you're automatically down and you have to be right as soon as possible.

    That should concern you. I know it concerns me.

    If I were you, I'd play the long game, not the short one.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Themes: market-outlook
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