Shorting

Why flexible investment is crucial

COLIN MCLEAN, SVM ASSET MANAGEMENT

As the bull market faded in 2007, long/short funds finally had an opportunity to show their paces. In the four year bull run, most hedge funds captured some market direction; the downturn was the chance for funds to show they could change tack. Weak and volatile stockmarkets were meant to be the perfect backdrop for protecting capital and demonstrating alpha. But with the credit crisis now more than one year old, not all long/short funds are delivering. This result could be a catalyst for fundamental change. Might it even restore the appeal of the traditional approach of hedge funds, less obsessed with beta?

The long term performance record of the hedge indices, now spanning several stockmarket cycles, has undoubtedly encouraged the industry’s growth of recent years. The statistics show that hedge funds have at times been slow to catch up with a sharp market rally, but overall the track record shows good long term performance with defensiveness in downturns. But, such has been the pace of growth since 2000, that the historic record spanning previous bear markets actually just reflects a minority of long term survivors. Most newer funds might behave differently now. The industry is dominated by more recent entrants, many of which were launched after the tough years of 2000 and 2001. Funds biased to net long exposure need to evolve. Easy gains from trading IPOs have disappeared and trying to remove market exposure with futures and indices may prove risky. Most managers have biases in their long positions, but overlays to reduce risk may not remove all the factors.

Short trading: not for the faint-hearted

Hedge funds have typically marketed leverage, but more recently the uncertainty of the market direction has undermined this strength. Returns can only be enhanced in this way when there is greater clarity on the market trend or stock alpha. Few can consistently call short term changes in market direction. Now, successful hedge funds will need a more flexible approach, possibly looking like a more traditional alpha-driven fund. Effective shorting appears likely to be in demand. It offers funds the potential for low correlation with others in the industry. However, this approach might not suit all managers: successful short trading can be challenging.

As has been seen this year, shorts can suffer sharp adverse price moves, with unexpected events triggering a scramble to close a crowded trade. Where positions are driven from sell-side analysis, they are more likely to be crowded. In running a short position, managers need to be aware of their fellow travellers with similar exposure and the potential for a price to jump. Even funds with different portfolio positions can correlate if they trade in the same way. Hedge fund managers need to think about the way they trade as a risk and this may not be captured by the portfolio analysis.

Avoiding the squash and the squeeze

The same crowd behaviour that can drive downward price momentum can also sharply reduce liquidity in a rally. Managers following similar risk management approaches (such as Value at Risk or stop loss) may all see the same catalyst to close a position at the same time. This danger is often overlooked and it highlights the importance of differentiation in risk management.


“There is now more competition for alpha and stock borrow can be tighter”


Some recent volatility in short positions has been driven by a superficial consensus approach to risk, which is all too easily gamed by other funds or central banks. Managers need to focus more on the way in which a short book is constructed, rather than assuming that risk management can always correct a problem. Ultimately, there may be no overlay or adjustment that can remove a specific risk, other than closing out that position.

Internally generated analysis, focusing on less well researched companies, can reduce the risk of being in positions that are crowded or oversold. Managers need a combination of high conviction on analysis, but pragmatism in dealing. Technical analysis can help timing, but gains cannot be expected without shorter term losses. It is important that risk management is not simplistic, but aims to manage risks holistically. A successful strategy should avoid, as far as possible, closing positions into a short squeeze. This may appear obvious, but not all managers recognise that their own psychology and risk tolerance can drive this behaviour, or that it can be unhelpfully imposed by a destabilising risk process.

Technical analysis can help identify the risk involved in extreme negative price momentum in shorts, leading to potential rebounds from an oversold position. Diversification of short positions can also help; generating ideas from different sources and methods and including some positions that may represent valuation calls on overbought stocks. In sharp market rebounds from an oversold level, shorts on overbought stocks will typically rally with a lower than expected beta. The danger of short squeezes is at its greatest in times of thin volume and low company newsflow, as in the summer months. For those genuinely identifying alpha-driven by downgrades, the company reporting season should be favourable. Short traders should focus on identifying the potential for asymmetric price behaviour: many smaller companies are more likely to be sold off on disappointment. Short positions in stocks with potential stock overhangs from founders and private equity, offer the prospect of a discounted share placing at some stage.

The changing face of the hedge fund industry

Even managers of those funds with records of ten years or more must recognise that the environment has changed. There is now more competition for alpha and stock borrow can be tighter. The way in which risk in short positions was managed in previous cycles may need to be updated to recognise the different behaviour of some of the newer entrants. Volatility has recently risen and this can be encouraged by actions of the regulatory authorities in seeking to stabilise markets.

The downturn of 2000-2002 showed that shorting can still be profitable even as the market rallies; it is at that stage that bankers find it worthwhile to put a business into administration. Funds which have low correlation to markets and competitors may see new investor interest. The industry needs to evolve and respond to recent challenges. It is time to re-examine the value of stock shorting.


Biography

COLIN MCLEAN

Colin McLean MA (Hons), MBA, FFA, FSIP, FSII Colin McLean is Founder and Managing Director of SVM and has been an investor for over 30 years. Prior to establishing SVM in 1990, he was CEO of Templeton International’s European operations and previously head of investments at two UK life assurers.


SVM Asset Management

SVM Asset Management focuses on UK and European equities, with a research team based in Edinburgh. SVM has run hedge accounts since 1992 and manages the SVM Highlander Fund (Europe equity long/short) and the SVM Saltire Fund (UK equity long/short).