Not all hedge funds will suffer
There are hedge funds and hedge funds, which is why the ban on short selling will have a varied impact across the industry.
It will almost certainly pull the rug from under funds that are reliant on the short selling of financial stocks in Europe and the US for part or all of their returns. The situation is worse in Australia because the ban on short selling covers all stocks and not just financials.
Funds that will be under pressure include: long/short equity, equity market neutral, dedicated short bias, convertible arbitrage, capital structure arbitrage and 130/30 funds.
According to Hedge Fund Research Inc, there were an estimated 10,000 hedge funds in the world with total assets of $US1,800 billion at March 2008, with long/short equity funds the dominant style of investment. But it is almost impossible to know how many different styles of funds will be affected by the ban because so many strategies rely in some way on shorting or equity related derivatives.
However, investment styles that are unlikely to be impacted by the ban include commodities, distressed securities, leveraged credit, bond futures arbitrage and global macro. Fund of funds hedge funds will be insulated from the damage caused by the ban on short selling because of the benefits of diversity. A typical fund of funds will have up to 200 funds.
One of the features of the hedge fund industry is the availability of regular pricing. Many funds report returns weekly but most are monthly. Fund of funds tend to report quarterly. So, depending on what type of fund you are invested in, the damage will be known either quickly or not until next month.
It is not unusual for hedge funds to have big swings in performance numbers from week to week or from month to month. That has given long term investors a tolerance for volatility and an expectation that poor performances will be turned around quickly.
But those wanting to withdraw funds at short notice will find it difficult. Most hedge funds have lock-in clauses that effectively force institutional investors to stay invested for periods of up to three years. It is possible to get out ahead of time but usually at great cost.
Retail investors will find that hedge funds sold through a prospectus include clauses allowing the manager to suspend redemptions indefinitely. In the case of large institutional only funds, big losses have tended to result in the funds being wound up in an orderly fashion and all remaining assets repaid to investors.
One aspect of the growth of hedge funds has been the ability of managers to construct funds that appeal to more conservative institutions such as superannuation funds. It is interesting to note that short selling as been a critical part of offering investors an absolute return product that provides an alternative to long only equity funds.
One of the fastest growing strategies in recent times has been the 130/30 concept, also known as 'short extension'. They are sometimes referred to as “hedge fund light”. About $US75 billion is invested in this style of hedge fund, according research published by Man Investments in July.
The biggest players in 130/30 funds are State Street Global Advisors, Barclays Global Investors, JPMorgan Asset Management and UBS Global Asset Management, the Man article said. In late 2007, about 16 per cent of US institutional investors were already invested in a 130/30 strategy with assets of about $US50 billion.
The 130/30 concept has taken off largely because of the inherent weaknesses in long only equity investment. As Man Investments says a traditional long only fund manager who does not like a particular stock can go underweight or hold more cash to express a negative view.
Whereas a hedge fund manager can short-sell stocks that are likely to underperform and use the proceeds from that to increase positions in conviction stocks that are likely to grow.
According to Man Investments, the 130/30 fund removes the long-only constraint and allows asset managers to short about 30 per cent of their portfolio on which they have a negative view or feel will underperform. The proceeds from the short sale are used to purchase an additional 30 per cent long positions.
The proportion of 130/30 funds that will now be caught up in the latest government intervention will depend upon how much they have relied on short selling of financial stocks for their returns. However, at least these funds have a large long only component that that can offset possible losses from the elimination of shorting.
Funds that are more heavily reliant on shorting of financial stocks will find it difficult to trade out of their problems over the next 30 days whereas others will find it is business as usual, although within a new framework of strict reporting requirements.
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