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SAN FRANCISCO (Dow Jones) -- Some equity hedge funds have quit short selling
stocks because the strategy is riskier in a rising market and has become too
crowded to be profitable. Instead, more managers are shorting exchange-traded
funds.
That's a problem, according to some experts, who argue that using ETFs to
hedge equity portfolios is a poor substitute for the real thing. Others say the
trend shows managers are adapting to a trying environment for short sellers.
Short selling involves borrowing a stock and then selling it. If the shares
fall, the trader can buy them back at a lower price and return them to the
lender at the original price. The difference is kept as profit.
The managers of equity hedges sell stocks short to protect their portfolios
from stock-market declines and to help them generate "alpha" -- industry
parlance for extra returns, above what's available from the market.
When stock markets rise, as they have been doing recently, short selling
becomes more difficult. Short sellers tracked by Hedge Fund Research lost 7.42%
through April this year. The Standard & Poor's 500 index was up roughly 5%
during the first four months of 2007.
But some investors and managers say a rising stock market isn't the sole
issue. The rapid growth of the hedge-fund industry and the leveraged-buyout boom
are also making the practice of shorting stocks less attractive.
"The single-stock-shorting game has become absolutely treacherous," said Jeff
Bernstein , co-founder and managing director of hedge fund Keel Capital
Management LLC. "Because of the growth of hedge funds, there just aren't that
many companies available to short now -- competition for shares to borrow has
gotten intense."
Bernstein and colleagues shut down Keel at the end of February partly because
of a lack of attractive short-sale opportunities. Without good short ideas, Keel
often had to trim its long positions to keep the fund within its strict strategy
parameters.
Keel also refrained from using ETFs to hedge its portfolio because that
strategy can inflate losses when stock markets fall, Bernstein said. It can also
be a duller tool, leaving managers betting against "good" companies that happen
to be in an index alongside more troubled rivals, he added.
Shorting ETFs
Still, facing investment headwinds, an increasing number of equity hedge funds
are shorting ETFs instead of single stocks. ETFs are indexed baskets of
securities that, like shares, trade on exchanges throughout the day. They can be
sold short or bought on margin, and many have listed options.
Given Keel's problems, Bernstein said that if he were starting a hedge fund
today, he would "absolutely" give the vehicle more leeway and allow it to short
ETFs.
ETF short interest has jumped 44% to $85 billion since the end of 2006, Paul
Mazzilli of Morgan Stanley (MS) wrote in a note to clients in late April.
There are eight ETFs with short interest greater than 100%, indicating more
shares are being shorted than are outstanding, he reported. The greatest short
interest is in ETFs that focus on regional banks, retailers, residential
builders and real estate, according to Mazzilli's report.
The KBW Regional Banking ETF (KRE) , which tracks lenders such as Synovus
Financial (SNV) , Chittenden Corp. (CHZ) and People's Bancorp (PFDC) , has short
interest of 1,838%, the analyst noted.
The Retail Holdrs ETF (RTH) , which tracks companies including Home Depot (HD)
, Target (TGT) and Wal-Mart (WMT) , has short interest of 466.9%. The SPDR S&P
Homebuilders ETF, which holds shares of such companies as Lowe's (LOW) , Pulte
Homes (PHM) and Meritage Homes (MTH) , has attracted short interest of 192%,
Mazzilli reported.
ETFs are easier to short because they're not subject to the "uptick" rule,
Mazzilli said. (The uptick rule on the New York Stock Exchange and Nasdaq means
that shares cannot be shorted unless their prices first rise.)
ETFs are traded more than some stocks, which also makes them easier to short,
Mazzilli added.
Benefits
Increased shorting of ETFs by equity hedge funds shows that managers are
adapting to a strong stock market that's fueled by leveraged buyouts, or LBOs,
according to Cynthia Nicoll , chief executive of Tremont Capital Management, a
fund-of-hedge-funds firm.
When a heavily shorted company is acquired, short sellers have to cover their
positions by buying back stock and returning it to a borrower. That process can
push shares even higher in what's known as a short squeeze.
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.
(END) Dow Jones Newswires
06-03-07 2234ET
Copyright (c) 2007 Dow Jones & Company, Inc.
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