More equity hedge funds turn to shorting ETFs
Continued from page 1
1 | 2
'We're concerned to see managers abandoning the whole concept of shorting single stocks. There is some of that happening out there.'
— Oscar Leal, 1794 Commodore Funds
By shorting a basket of shares, rather than one stock, there's less chance of being hit by a big short squeeze when a buyout is announced.
"Hedge-fund investors hire managers to make money in all types of markets, and this strategy works in this type of market," Nicoll explained. Once LBOs become less prevalent and the stock-market cycle turns, equity hedge funds will start shorting individual shares again, she predicted.
ETFs can also be used in combination with other positions to isolate a stock that's difficult to borrow, according to Joe Weinhoffer, chief executive of Quadriserv Inc., a New York-based firm that specializes in helping hedge funds and other traders borrow securities.
One hedge fund with which Weinhoffer is familiar was struggling to borrow a stock and instead shorted an ETF that contained the shares, he said. The manager then took long positions in all the other stocks in the ETF.
"That gave them short exposure to that single stock through the ETF trade," Weinhoffer explained. "That's expensive, but they believed the stock was going to go down."
Problems
But there are also problems with managers using ETFs to hedge their equity portfolios, Weinhoffer said.
ETFs have more moving parts than a single stock, he explained. If a hedge-fund manager wants to short a couple of hard-to-borrow biotech stocks, for example, the manager could more easily bet against an ETF covering that industry.
But when managers do that, they're not just shorting the two stocks they want to target; they're also betting against several other companies that they may not know as much about, Weinhoffer said. "There's extra risk there."
Bernstein noted that equity hedge funds typically go long stocks with high betas (if the market goes up or down 1%, these stocks will go up or down 1.5% or 2%, for example).
If funds are also short an ETF, these usually have a much lower beta (they move more in step with the market). So, if the market goes down 1%, the ETF position may rise by 1%, but the long positions could go down by 1.5% or 2%, he explained.
Increased shorting of ETFs also poses a dilemma for funds of hedge funds, which allocate money to a range of different outside managers, Bernstein said.
These investors like to invest with managers who focus on different strategies and hold different securities. That diversification cuts the risk of big losses. But if a lot of managers are shorting ETFs, returns and losses may be more correlated than investors realize, Bernstein explained.
ETFs are also indexes, and so, by definition, they provide so-called beta -- that is, the return generated by the market. Hedge-fund managers are in the business of creating alpha and outpacing the market benchmarks. So if they build short positions with ETFs, that part of their strategy will track whatever portion of the market they're betting against. That could end up looking more like beta than alpha.
Investors may be better off investing with a mutual-fund manager who is a great stock picker, then shorting ETFs themselves, Glen Dailey, head of prime brokerage at Jefferies Group, said, adding that this strategy would incur fewer fees.
"Why would people be willing to pay a 20% incentive fee for a hedge-fund manager who's just shorting ETFs?" he said. "It's great as a tool but not a good hedge-fund strategy."
Bernstein said this idea makes sense, but he added that in practice it would be much harder to do successfully. "A hedge-fund manager will say, 'I'm rotating and changing short exposure all the time to create excess returns,' and some people are very good at that," he said.
Other investors say they want hedge funds to continue shorting single stocks rather than ETFs and point out that there are still lots of potentially profitable short ideas available.
"We like to see individual short disciplines, but we're somewhat flexible, and we understand the difficulties right now," said Oscar Leal, a portfolio manager at the 1794 Commodore Funds, which invests in hedge funds. "We're more concerned to see managers abandoning the whole concept of shorting single stocks. There is some of that happening out there."
Despite strong equity markets this year, some dedicated short sellers are still making money.
Kingsford Capital, a short-selling investment firm that specializes in deep research of small companies, was up roughly 1.5% through the end of April, according to two hedge fund investors who declined to be identified.
Alistair Barr is a reporter for MarketWatch in San Francisco.
Related Blog Posts & Articles
expected to build on new highs in coming week
News 
Market Data 
Discover 
