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New Managers May 2013

Guest Article - A short note on short selling: Four post-crisis headwinds

Introduction Short selling is an integral component of the hedge fund business model. In addition to mitigating market risk, hedge funds can generate excess returns by identifying overpriced securities. With the ability to both buy and short stocks, hedge funds have roughly double the opportunity set of long only investors, a critical competitive advantage

Shorting has always been more difficult than buying stocks. Equity markets tend to appreciate over time, so even highly talented short sellers are likely to lose money on an absolute basis in most years. Heavily shorted stocks are often prone to significant price volatility and stock prices can run up before rationality sets in. Theoretical upside is capped at 100% while downside is unlimited. In extreme cases, regulatory changes can materially disrupt the market, such as the temporary short selling ban on financial stocks during the height of the financial crisis.

Based on internal studies, hedge funds had difficulty making money by shorting stocks during 2010 and 2011. In this note, we briefly explore four factors that have created headwinds for short sellers post-crisis:

  • Lower interest rates have reduced the short rebate and made shorting more costly on an absolute basis.
  • Stock lenders have become more proactive about increasing borrow costs for difficult to borrow securities which cuts into fund profits.
  • A concentration of capital among larger funds has narrowed the opportunity set for large funds.
  • Regulatory changes have increased disclosure and created other challenges.

It's important to note that the short side of the market in many ways is antiquated and much more op......................

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This article was published in Opalesque's New Managers a top-down monthly analysis, news and research publication on the global emerging manager space.
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