What it takes to win: The challenges of short seller analysis

One of the great thrills for a hedge fund manager is a winning short trade. Short selling is really, really hard. It is the Triple Lindy of Wall Street. The odds are stacked against the short seller.

Evaluating a manager’s skill as a short seller is not quite the Triple Lindy, but it isn’t easy either. In order to provide allocators with a stronger framework for manager analysis, we’re discussing the challenges short sellers face, the purposes of a short book, and the mechanics of short selling —  concluding with specific methods for short book analysis.

Short sellers are brave

The odds are stacked against the short seller. For shorts, the maximum return is -100% and assumes the stock price goes to $0. For longs, the max return can be 100%+. Relative to longs, the required diligence is more intensive, the trade duration is shorter, sizing is smaller, and upside is less; ultimately, shorts deliver a comparatively worse return on time. And as shorts go against you, the position size increases and accelerates the speed of a risk rule violation. Covering a portion of a short to manage sizing means reducing shares and crystalizing a partial loss. On the contrary, when a long goes down, the convicted investor can buy additional shares to adjust the position to a larger size.  

The best short ideas must be timed just right, otherwise they may become expensive to borrow which reduces the maximum net return. Structuring trades with options is costly as downside volatility skews more expensive than at the money puts. While a bearish put spread makes options less expensive, put spreads limit upside. The out of the money put cancels volatility capture as the trade works in your favor, especially with a dramatic price move. If timing is off, there is more premium to pay in order to roll the exposure.  

Short sellers must also consider the risk that "future buyers" are setting an artificial floor. Wall Street Bets, Roaring Kitty, and $GME exemplify the dangers of crowded shorts and weak short book risk management.

If that wasn’t enough, you must be comfortable with being lonely, because EVERYONE (and I mean EVERYONE) is against you. Management is incentivized to generate shareholder return, "Long Only’s" are incentivized for prices to go up, and active investors are incentivized to be agents of change.

Meanwhile, the sell side cheerleads stocks and puppets bull cases to maintain access to management. Lurking in the shadows are private equity and strategics, always aiming to buy assets at low prices. The media likes to pin blame for declining markets on "evil" short sellers, and even the government can change the rules and ban short selling in the middle of the game to protect strategic businesses like banks in the midst of harsh market environments.

It's a hard road to be sure. 

Understanding short selling data

With that resounding endorsement for short selling, why bother? Well, a short book can serve four (not necessarily mutually exclusive) purposes.

1. Source of absolute return for a manager who is skilled in identifying unique idiosyncratic short opportunities
2. Source of leverage for a manager who is skilled at generating alpha on both sides of the book and recycling the cash in-flow from shorting a stock into longs with a goal of boosting gross long exposure above 100%
3. In combination with a well-managed long book, the short book can cancel systematic market risk to isolate idiosyncratic risk reflected through deeply researched single-name or paired investment ideas
4. Shorts can be tied to specific longs or other vehicles for various trading strategies

Managing risk for a short book is imperative. An allocator with access to position level data can gauge a manager’s risk management measures as well as the purpose and quality of the short book. Before we go there, let’s review the plumbing of short selling. To short a stock, a hedge fund needs to borrow shares of the stock through its prime broker. Prime brokers source from beneficial owners. Some prime brokers enjoy captive sources like asset management arms, private banks, and retail brokerage businesses. Outside sources include large independent asset management companies including index funds and ETF houses. The dirtiest form of a borrow is from faster owners like other hedge funds or trading shops. The more crowded the stock, the more prime brokers need to utilize less stable locates from the faster owners.

An "easy-to-borrow" name is referred to as general collateral (GC). The hedge fund earns a ‘rebate’ on the cash it receives for borrowing and then selling a GC name of the fed funds rate less a spread. Given the Fed’s zero interest rate policy, rebates have been near-zero-to-negative since the Great Financial Crisis. For non-GC names—typically 10-15% of the investible universe—the spread widens. For hard to borrow names, the rebate can be minus a few points to as bad as -99%. Many hedge funds are multi-primed, so their traders check rates against each of their primes to ensure competitive rebates.

One must also consider that the securities lending market is an overnight market, which means a hedge fund in a trade can be re-rated overnight. Part of the "service" a prime broker offers hedge funds is its best effort to maintain stable locates and rebates when a short starts to get juicy. This can be nigh impossible when the borrow market for a stock severely tightens.

Information provided by SEI through its affiliates and subsidiaries. This information is for educational purposes only and should not be considered investment advice. The strategies discussed herein are complex and are not suitable for all investors. Please note the Triple Lindy YouTube video is not owned by SEI and nor does SEI hold any liability for any errors or omissions. The video has been included for educational purposes only.