Shorting and market efficiency
Hedge funds, along with proprietary trading capital, dominate the shorting of shares. Day traders and individual punters short shares in the United States, but most shorting is carried out by hedge funds. A number of studies have demonstrated that the ability to sell short contributes to the accurate and efficient evaluation of financial instruments. For example the paper “The Importance of Short Selling”, published in September 2009 by the Asia Securities Industry & Financial Markets Association makes the case: in markets with bans on short selling, market participants with negative information that do not hold inventory of securities will be constrained from selling and their information will not be fully reflected in the prices of the instruments. Further restrictions on short selling can in this way increase the magnitude of over-pricing and subsequent corrections or reduce the speed of price adjustment to private information, according to this and other research. So impediments to short selling can impact market efficiency.
Disclosure to the regulators
The newly created European Securities and Markets Authority will have the power to temporarily ban short selling altogether. It is proposed that investors will need to disclose short positions to regulators if they exceed 0.2 per cent of a company’s issued share capital, and to the rest of the market if the short position exceeds 0.5 per cent. The proposed regulations would also require that short selling of government debt be disclosed.
Visibility of short positions to regulators is not much of an issue. It will be something of an administrative chore to report all short positions greater than 0.2% to a regulator, and then all subsequent changes to such positions, but it is doable. This new reporting activity will be part of the long-standing trend for compliance and administrative matters to be an increasing drain on hedge fund company profitability. Of more significance is the impact of public visibility of hedge fund short positions.
Disclosure to the markets
Does this matter? Yes it does for market efficiency, but also because of the potential for more frequent and even more exaggerated short squeezes, and also for the impact on the managers’ edge(s).
For a short position to be publicly visible it would have to be equivalent to 0.5% of the outstanding capital of a European listed company. Immediately I will look at the materiality of this level for hedge funds, and follow on with the impact it could have.
A key question becomes “How big would the fund have to be for the largest short positions to be visible to the market?” The majority of shorts amongst European equity managers are STOXX 600 Index constituents. Not that hedge funds don’t short mid-cap names, but they have a profound preference to short liquid securities.
The smallest company in the STOXX 600, Europe’s index of blue chips, Solarworld AG, has a market capitalisation of €1.008 bn. So a €2m short position in Solarworld would be known to regulators and a position of €5m would be known to the whole market.
The most concentrated equity hedge funds are “focus funds” which run with concentrated portfolios of what are considered the best ideas of a manager. Such a fund might have 25 long positions and 10 short positions with a gross balance sheet of up to 120% of equity. A typical balance sheet disposition might be, say 75-90% long and 15-30% short. This would make a typical short in a concentrated equity hedge fund 2-4% of equity.
Taking the larger end of the typical band, a focus-style equity hedge fund might have the largest shorts sized at 4% of the equity. If the largest short of a hedge was in the smallest of the stocks in the universe its significance for reporting is a function of the fund size. So a €100m concentrated-style hedge fund portfolio might have a €4m position in Solarworld, equivalent to 0.4% of the shares outstanding. That means the equivalent proportion short position would have to be 1.25x larger in absolute size to be visible to the market. Or to put it another way, the short position would be public knowledge at a 4% portfolio position for a €125m sized hedge fund.
Materiality of public disclosure
Most hedge funds are not of the “best ideas” or concentrated portfolio type. For most equity hedge funds a 2% short would be a large, or conviction position. So, for the way most hedge funds in Europe manage their portfolio shapes/positioning their largest short positions will become visible to the world at large if they manage €250m or above. If you run a €500m hedge fund a typical 1% position would become public knowledge if it were a company at the bottom end of the capitalisation of the invested universe. If a manager looks after a 1bn hedge fund portfolio invested in European large caps, a 2% conviction short position would be known to the wider world if the stock in question was in the ranked lower than 303rd in the STOXX 600 Index by capitalisation.
The same manager who runs €1bn in European equities would have to disclose in a publicly visible form a typical 1% short position if the company in question were in the bottom 123 stocks in the STOXX 600 Index.
UK-focused funds may be impacted
The public visibility of short positions of UK equity focused hedge funds could well be more problematic for the managers than for managers of European equity hedge funds. UK-focused hedge funds tend to invest in mid and large cap stocks. The universe for them is within the constituents of the FTSE-350 Index, and the smallest 350 Index constituent is TR Property Investment Trust. A £177,000 short position in TR Property would be known to regulators and a £443,000 short position would be visible to the whole market, that is €205,000 and €515,000 respectively. The median sized FTSE-350 Index constituent has a market cap of £1.1bn, so a typical UK focused hedge fund position would be disclosed to the whole market for a holding valued at £5.5m (€6.39m).
Short squeezes and anticipated flows
Transparency of short positions in shares to the whole market can be very damaging. Even when the specific fund or trading house with the short position is not known, market level data is tracked assiduously so that shares known to have large short interest are periodically ramped to shake out the loose shorts. The extreme case of short squeezing in Europe took place in October 2008 when Porsche engineered a short squeeze in Volkswagen shares. VW shares appreciated 82% in a single day to become for a brief time the world’s biggest company by market value. The squeeze put the Trident European Fund out of business.
But it is not just in the extreme case that short squeezes are damaging to the party that is short – right through market history there have been examples of rallies in low-quality counters that persist because of pressurised buying, that is buying for short-covering. Stock price behaviour thus changes in a bad way – stocks with low betas can become high-beta plays on market moves because the markets knew there were big shorts. UK retailers acted that way in 2008, and many highly-leveraged companies had violent up-moves in the middle of 2009, for example.
When traded markets have specific holding information and know about large-scale flows into or out of hedge funds then market-makers change prices adversely and proprietary capital traders position against the fund flows. This happens when a fund has big redemptions and has to liquidate large equity holdings, and also when large flows in (subscriptions) turn into portfolio trades. It can happen in event driven investing – when the European Commission stopped General Electric taking over Honeywell in 2001 the shorts in GE and longs in Honeywell were killed. It also occurs in other markets. Adverse pricing happened in the market for MBS in 2008. When the leveraged loan market imploded in 2008 primebrokers and banks seized the loans of some funds and dumped them into a market with no bids. When Amaranth controlled one side of the natural gas futures market there was no exit route feasible for the size of trade. So the disclosure of position level information to the general market can have adverse impacts on hedge funds in extremis, but also impacts hedge funds routinely and periodically in more normal times of market action.
Short position asymmetry
In part the suffering of hedge funds on short books is a function of the peculiarities of shorting. When long positions are successful the position size goes up, and when longs go wrong the position size shrinks. For shorts the opposite happens. When short positions go wrong (the share price goes up) the position size increases, and successful shorts shrink in position size as the share price falls. So the psychology of shorting is difficult and they are problematic to manage in a portfolio. At the best managers have to decide whether to add to successful shorts (to maintain size), at the worst managers have to decide where their pain threshold lies when shorts go wrong.
One unintended consequence of short position disclosure rules is opening up hedge fund managers (and the capital of their clients) to more frequent and potentially exaggerated short squeezes. The second consequence may be more damaging, which is the attrition of the intellectual property of the managers.
Information, intellectual or flow edge
Hedge funds are partly paid their management fees to be the best informed investors on the Street. Historically for Michael Steinhardt, and currently for Steve Cohen this means being the first call for analytical information from the sell-side such as estimate revisions and recommendations, and also being kept well briefed about market flows, blocks and positioning. For hedge fund firms like Polygon, Och Ziff or Maverick the founders intend their funds to be advised by the best fundamentally informed investors on the Street. High quality analytical minds are brought to bear on specific sectors so that the analytical staff has the intellectual edge on their stocks under coverage. This may require paying for primary data research (shop footfalls for example), or using expert networks like Gerson Lehrman or AlphaSights. Arguably firms like Odey Asset Management and Lansdowne Partners combine bottom-up analytical edge with a fiercely intellectual macro-economic fundamental element to the process.
Less so for trading-oriented firms like SAC but certainly at most hedge fund firms, portfolio managers prefer to have core, long-held positions, even on the short side. Although shorts tend to be traded more than long positions, still and all, fund managers like to have stable long holding period shorts. These high conviction shorts are sometimes called structural shorts. They have to be held for solid fundamental, well-researched reasons.
When The Children’s Investment Fund and its manager Chris Hohn came to prominence in 2004/5 a fan club developed along the lines of that seen around the investment strategies of Warren Buffett. When filings with the SEC disclose that Buffett has bought a new stock many followers do the same. Hohn’s fund got to a size that often positions were big enough to have to be publicly declared. After they were known to be in his fund, investors piled into the same positions. The investment process at TCI is almost painfully detailed in its depth before a new position is initiated. There are dedicated analysts and data trawling is exhaustive. A significant safety margin is built into purchases, so the value evident has to be significant at initiation. For those hoping to enjoy the halo effect of Chris Hohn’s selections the investment process is a lot shorter – if TCI owns it that is good enough for them. The TCI holdings used to enjoy a significant uplift in price when they became public knowledge, so there was some benefit to the investors in the fund. But in essence the fan club purchasers were piggy-backing on the work done by The Children’s Investment Fund Management.
Something analogous is plausible as a consequence of the disclosure of short positions as proposed by the EU. Whilst it is unlikely that the man in the street will replicate the significant short position that they see Gradient Capital have put into place, one of the fears of hedge fund managers is being in a crowded short for all the reasons given above.
Bad for hedge funds and market efficiency
Increased visibility of shorts will not only allow for more short squeezes, but the intellectual property or information edge of hedge fund managers will be under threat at the margin. Shorting is difficult enough without the pressure on the short book P&L from increased transparency. The proposal from the EU to disclose short positions should be resisted in its present form. It would be bad for hedge funds and bad for market efficiency.