Hedge Fund Strategies: Short Selling

Short-selling by hedge funds attracted a lot of press attention in 2008, especially when the Securities and Exchange Commission, acting in concert with the U.K. Financial Services Authority, temporarily issued a ban to prohibit short selling in financial companies. Regulators wanted to “protect the integrity and quality of the securities market and strengthen investor confidence” at a time when markets were dropping fast.

Short sellers were among the first to uncover (and take advantage of) financial problems with Enron, WorldCom and Bear Stearns. However, when markets crash, short sellers often get blamed because even legitimate short transactions in well-known stocks can drive prices down even faster.

The ban on short-selling was intended to be a temporary “time out” for hedge fund managers to help the markets settle down. But by the time it expired a month later, many experts felt it only added to market confusion and didn’t stop the slide in stock markets around the world.

So what is this demon that has regulators up in arms? In simplest terms, if an investment manager thinks a particular security is going to fall in value, for whatever reason, he borrows the security at today’s price and sells it. He then buys it back at some point in the future to cover the loan. If the price actually goes down, he’s made a tidy profit on the difference between the initial sale price and what he bought it back for.

Of course, if things go the other way, and the price of the security goes up, he loses money.

Short-selling is a crucial part of the hedge fund universe. It’s an important tool in the hedge fund manager’s arsenal and is really what puts the “hedge” into hedge funds. For example, as we’ve seen with our previous discussion of market-neutral strategies, a manager can hedge overall market risk.

If a manager thinks a particular stock will outperform the market, he can buy shares in that company (go “long” or hold assets in company “A”). Then he can “short” the market in which company A resides (the S&P 500, for example).

Thus, even if the market goes down, the manager can still profit if company A’s stock declines less than the overall market. (See “Hedge Fund Strategies: Market Neutral” for more details.)

Short-selling, along with leverage, are two fundamental strategies for hedge fund managers. And while they are both often associated with equities, these strategies can be applied to any type of security: stocks, bonds and derivatives.

How Short-Selling Works

Short-selling requires that a manager borrow securities he doesn’t own usually from a firm called a prime broker. Some of the major prime brokerage firms (still standing) include Morgan Stanley, Goldman Sachs, Deutsche Bank, Merrill Lynch and CitiGroup.

The prime broker acts as the lender. It charges an interest rate for lending securities which can be an important source of revenue for these firms. This lending-related revenue also tends to be relatively steady, compared to the volatility of trading commissions and trading profits.

In choosing a prime broker, a hedge fund manager will want a broker that has excellent access to a wide range of securities to make borrowing securities easier.

The manager will deposit funds (or other securities) into an account with a prime broker to use as collateral. Then he borrows shares to sell right away. This is not as difficult as it sounds since investors who hold stock in a margin account with these prime brokers have usually consented to having their stock lent out to other investors.

The proceeds from the sale of the borrowed stock go into the hedge fund manager’s account where it earns interest. This interest is split between the lender of the shares, who earns a fee; the broker, who earn a commission for arranging the transaction; and the short-seller, who earns the remainder of the interest.

Next time, we’ll look at why hedge fund managers have to keep a close eye on their shorts.

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March 9, 2009 at 9:04 am

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