Friday, June 26, 2015
NYT: The Loneliness of the Short-Seller
For some, they are the scourge of Wall Street. Yet short-sellers — investors who stake bets against stocks — are often the first to sound the alarm on a market’s froth or a company’s fraud.
Now, six years into a bull market run, with stocks in the United States smashing one record after another, these naysayers have all but lost their voice.
William A. Ackman, who has yet to prevail in a billion-dollar bet against Herbalife, said he would “think very hard” before making another short bet. James S. Chanos, the short-seller who helped expose Enron, and who has long been seen as the fiercest of the short-selling bears, is now adding a fund that will instead focus on buying stocks.
“Short-selling is an incredibly lonely proposition,” Mr. Ackman said in an interview.
Critics accuse short-sellers of being unpatriotic and say their strategy of taking public aim at certain companies — and then profiting from the fallout — is akin to market manipulation. But proponents argue that they play a critical role in tempering market exuberance.
“People often don’t recognize the importance of short-selling in identifying fraud, deflating bubbles and being the buyers of last resort when stocks fall,” said Mr. Ackman, who for more than two years has publicly argued that the vitamin supplements company Herbalife is a pyramid scheme. (Herbalife rejects that characterization.)
As stocks continue to climb higher, some worry that absent a healthy dose of skepticism in the market, investors rushing to participate in the rally are laying the foundation for the next crisis.
Being a short-seller is no longer worth the trouble for many hedge fund managers. Investors don’t want to miss out on a rally that lifted the Standard & Poor’s 500-stock index to a record high in May. Catering to that demand, hedge funds have abandoned, or pared back, their short positions. Overall exposure to long positions by hedge funds has reached a high not seen since 2007, a year before the financial crisis. Short positions, meanwhile, are much lower than they were at that time, according to research by Bank of America Merrill Lynch.
Betting against the market is not worth the expense, either. To take a short position, traders sell borrowed stock in a company they think is overvalued with the hope of buying it back at a lower price. If the stock price goes up instead, short-sellers have to buy more stock in order to “cover” the position, which in turn pushes prices higher. Over the last several years, traders have hemorrhaged money on such bets, reporting percentage losses that are sometimes in the double digits, according to data compiled by HFR, a research firm.
In 2014, more than $1.3 billion flowed out of short-biased funds, a result of losses and investors withdrawing their money, according to HFR estimates. Within the universe of 8,431 hedge funds, there are only 17 that are short-biased, according to HFR data. (The Financial Times earlier reported on the HFR data.)
Hedge funds that shorted certain high-flying stocks have been pulverized. Take Tesla, the maker of luxury electric cars. For years, it was a favorite among short-sellers, who questioned everything from its business model to its forecasts for revenues. Despite the pessimism, the stock suddenly gained more than 600 percent from early 2013 until September of last year. The share price has since come down slightly, but at around $260 a share it is still much higher than the roughly $30 a share it traded before the run-up.
“It’s been an extremely difficult period for many short-biased managers, as negative performance during this prolonged bull market has led to capital outflows, forcing some to throw in the towel as others struggle to keep the lights on,” said Joseph Larucci, a co-founder of the hedge fund advisory firm Aksia.
It wasn’t always this way. In the turmoil of the financial crisis, short-sellers were king. Those who bet on the collapse of Lehman Brothers and Bear Stearns made a mint. As the market spiraled violently downward in 2008, the Wall Street banks that were still standing pointed the blame at short-sellers. In September of that year, the Securities and Exchange Commission issued a temporary ban on short-sellers.
Nevertheless, by the end of 2008, short-biased hedge funds had made an average return of 28 percent, compared with a decline of 38 percent across the S.&P. 500, according to HFR.
Stepping in to pick up the pieces in the aftermath of the crisis, the United States Federal Reserve pumped trillions of dollars into the financial system, pushing up the price of assets. The government also tamped down interest rates to all-time lows, prompting individual investors with retirement and pension funds to look for investments that would yield bigger returns than Treasury securities.
“Every market has its own characteristics, they all have a story and narrative, and this one really is all about the central bank,” said Mr. Chanos, founder of the hedge fund Kynikos Associates. The narrative, he added, is that “the central bank has your back and that’s embedded in everybody’s psyche and portfolio.”
This confidence, in turn, fueled a boom in mergers and acquisitions and spurred companies to buy back record numbers of shares from shareholders — two of the worst nightmares for any short-seller. To mitigate the risk, many moved to diversify the number of companies they were shorting.
Investors, for their part, have sought to place their money with hedge funds that offer long-only funds, according to a Deutsche Bank survey of 435 global hedge fund investors holding half the industry’s $3 trillion in assets under management. Nearly half of those surveyed were already allocated to long-only hedge funds, while 38 percent said that they planned to increase their allocation to such funds.
With this tidal shift in demand, short-sellers have looked to raise money by adjusting their pitch to investors. Mr. Chanos’s Kynikos Associates, for example, is pitching a new fund to investors that will take a portfolio of long positions and overlay the firm’s traditional short portfolio, according to marketing documents reviewed by The New York Times. The amount of money that Kynikos manages has more than halved in the last five years, to $2.5 billion today from $6 billion, according to regulatory filings.
Even as investors embrace the market rally, there are signs that not everyone believes it is sustainable.
“I do think it is an incredibly unloved bull market,” said Eric Peters of Peters Capital Group. “It is certainly unlike any major bull market that I have seen in that new highs have occurred in the absence of euphoria.”
Pointing to options trading, Mr. Peters said the cost for investors to insure against a 10 percent decline in the S.&P. 500 relative to the cost of insuring against a 10 percent rally in the S.&P. 500 is three times higher than its historical average.
“It’s telling you that people are willing to pay a lot more for protection on the downside in a really big way,” he said.
And some investors are starting to look around for short-sellers to help them find the exits. Jim Carruthers, a former manager at Daniel S. Loeb’s Third Point, raised more than $200 million from investors — including Yale’s endowment fund — last year to start a short-biased fund.
The other short-sellers who remain, meanwhile, have also been proved right on occasion. Whitney Tilson reaped a windfall this year when Lumber Liquidators, a flooring company he attacked for more than a year, accusing it of selling an unsafe product, came under pressure after a report by “60 Minutes” in March. Shares of Lumber Liquidators tumbled 25 percent the day after the broadcast, which accused it of selling a type of Chinese laminate flooring that contained dangerous levels of formaldehyde.
Other short-sellers are waiting patiently in the wings, among them Bill Fleckenstein. He planned to start a short fund last year, but later decided it was not possible to do successfully while the central bank continued to pump money into the financial system.
“You can keep the party going, but there is going to be a hangover,” Mr. Fleckenstein said.
Mr. Chanos used a similar analogy to describe the market today.
“As one famous banker once said,” Mr. Chanos recalled, referring to a now famous 2007 comment from Charles O. Prince, then the executive of Citigroup, “it’s hard to stop dancing while the music is playing.”
Posted by Bud Fox at 5:51 AM