The Shorts Run From the Bull

One of the more appealing ideas in hedge funds and mutual funds is the long-short strategy, in which funds buy a portfolio of attractive stocks while selling the ones likely to underperform the market. The strategy, which comes in several variations (130/30 is the best known) uses moderate leverage, should produce a cushion in bad times, come close to matching long funds in good times, and reward smart stock picking.

In real life, it’s not that simple. Bloomberg’s Nikolaj Gammeltoft and Alexis Xydias report today on the squeeze at long-short hedge funds. In December, the most-shorted stocks in the Standard & Poor’s 500 Index gained 5.1%, easily outperforming other shares as the market turns bullish and funds that have gone short rush to cover their positions.

Yikes. Let’s unpack that. The shares that everyone expected to fall have not only gone up, but have done better than others. How could that happen? One possibility, of course, is that they were all great companies to start. Much more likely, however, is that investment managers are reaping the bitter bounty of following the crowd — shorting shares that are already badly beaten down, and buying them as they rise.

The chart of mutual fund returns above tells the unfortunate long-short fund story. Gammeltoft and Xydias talk specifically about hedge funds; the issues with long-short mutual funds are similar, and the data is easier to sift through. Compared to large-cap long-only funds, long-short funds have been lackluster — even over five years, a period that covered a historic market drop (Morningstar’s full data is here). Versus small or mid-cap funds, the long-short funds do still worse.

There are successful short sellers out there. James Chanos is one. Bill Ackman is another; a story today delves into Ackman’s continuing battle with Herbalife. As the Herbalife story illustrates, though, folks like Chanos and Ackman tend to go all in: they’re interested in the companies with crumbling foundations that they believe will go to zero. Their approach is very different from that of long-short funds, which generally try to short sectors that will underperform the broader market. That strategy turns out to be more difficult to execute than it first appears.

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