Picking losers in the stock markets was once among the favourite, and most feared, tools employed by hedge funds. Today, many fund managers are struggling to make the strategy work and are desperate for market conditions to change.
Carvana, one of the US’s most-shorted stocks, has doubled its share price so far this year, stinging funds that had doubted the prospects of the self-styled “Amazon of used cars”.
Aerospace company TransDigm Group, identified by high-profile short-seller Andrew Left as a key candidate for a decline, dipped during the wider market’s sell-off late last year but has otherwise been on the rise for a long time, including a 40 per cent gain this year.
These and other flubs for short-sellers highlight how tough it is to bet against listed companies in an era of easy money. A decade of rising stock markets that took the S&P 500 to a new record high on Tuesday has been a tough backdrop. In particular, managers say a ‘dash for trash’, fuelled by trillions of dollars of quantitative easing by central banks, has pushed up poorer quality stocks, making it harder for asset managers to profit from fundamental analysis.
Shorting — which involves borrowing shares, selling them in the market, and then buying them back at what funds hope will be a lower price — is “one of the hardest and most complex aspects” of investing and “will cost you a lot if you get it wrong”, says Daniel Caplan, managing director in Citi’s prime finance business.
“In a more benign macro environment . . . it’s natural that short selling has not been in vogue or paid off,” he says.
Among the most painful negative bets this year, according to data group Breakout Point, are Greece’s Piraeus Bank, which has rallied about 115 per cent and which has been shorted by funds including London-based Lansdowne Partners. Italian asset manager Azimut Group, also targeted by bears, has gained 80 per cent.
Lansdowne’s Peter Davies and Jonathon Regis attempted to explain some of the fund’s indifferent performance in a letter to investors, seen by the Financial Times, earlier this year. In it, they wrote: “Investors seemed willing to ignore obvious structural questions (particularly in US consumer areas) for much of the year, given immediate cyclical strength.”
Lansdowne’s main fund lost 7.4 per cent last year, although it is up 2.1 per cent this year.
Another popular short, the retail sector, is not paying off either. Retail stocks within Europe’s Stoxx 600 index account for the heaviest concentration of short interest, according to data compiled by Citi, as funds bet on more pain for shops on the High Street. However, that sub-index has rallied more than 20 per cent this year, well above the broader index’s 16 per cent gain.
Conditions today are a far cry from short-sellers’ heyday in the financial crisis, when funds such as John Paulson’s Paulson & Co and Lansdowne made millions betting against stricken bank stocks.
“Short selling is regime-dependent,” says Paul Marshall, chief investment officer and founding partner of Marshall Wace, one of the world’s biggest hedge funds with $39bn in assets. The fund hit a jackpot in February when three stocks it was shorting posted the biggest one-day falls on the UK stock market.
In theory, the shorts should be due a revival. Monetary easing has helped keep alive some companies that would have died without access to cheap finance. The ending of QE should mean greater sifting of stocks.
Data from SYZ Asset Management shows that the correlation between stocks has generally been higher after the credit crisis than before it, making it hard for hedge funds to make money by targeting individual stocks. But correlation has been falling in recent years and, while it picked up sharply in the recent market rally, is still just below its post-crisis average.
“We are . . . back to fundamental-driven markets where short selling makes sense again,” says Cedric Vuignier, head of alternative investments at SYZ. Earlier this year hedge fund manager Crispin Odey agreed, saying the market was beginning to “differentiate” again between good and bad companies.
Not all short-sellers are struggling. Some have been able to profit from vocal, activist campaigns, backed by detailed research, usually targeted at a relatively small number of companies.
Carson Block’s Muddy Waters — famed for a 2011 campaign against China’s Sino-Forest, which later filed for bankruptcy — was up about 20 per cent last year. Spruce Point Capital, which manages about $200m and which has vocally targeted stocks including Carvana and Aerojet Rocketdyne, was up about 25 per cent.
However, even some of these funds would welcome a change in market conditions.
“Part of what’s causing this [market] overvaluation is low [interest] rates for too long a time,” says Ben Axler, founder of Spruce Point. “Rising rates would certainly dent the market rally. Corrections are healthy.”
Additional reporting by Lindsay Fortado