Short Selling Strategies

Hedge fund managers pursuing a short-selling strategy borrow stocks of several companies from a third party (often a broker) in order to sell them short in the public market. The resulting short portfolio is expected to profit from decreases in the prices of the shorted securities. At some point in the future, the manager repurchases the shorted securities on the open market and returns them to the lender. If the shorted stocks experience price decreases, the strategy realizes a profit since the stocks are repurchased for less than the value at which they were sold. If prices increase, the strategy incurs a loss. In the interim between short sales and repurchases, the cash proceeds from the initial short sales earn interest known as the short rebate interest. Thus, short-selling strategies derive returns by repurchasing stock at a price less than the short sale price and by earning the short rebate interest.

1 Fama, E. and K. French, "The Cross Section of Expected Stock Returns," 47 Journal of Finance (2) (June 1992), 427.

Candidates for short sales are selected using bottom-up analysis. In addition, managers identify companies with questionable accounting practices that are expected to have announcements exposing the fundamental problems within the company. Short-selling strategies can also be executed through the use of individual stock or index derivatives such as forwards, futures, and options.

Issues Specific to Short-Selling Managers

Short-selling strategies are fraught with problems not incurred by long-only money managers. To begin with, short selling requires that a broker or other third-party be willing to lend the securities for sale. If the securities needed are not available for borrowing, the profit opportunity will be missed. Even if the stocks can be borrowed and sold short, the lender has the right to call the stock back, creating uncertainty in the borrowing process. Sudden demand for a stock may cause lenders to call their stocks back at an unfavorable price, resulting in losses on the short portfolio. Intermediaries in the short sale often require that the short seller post margin of 30% to 50% of the value of the shorted stock. Such margin requirements tie up the capital of the short seller, costing him the opportunity to make another profitable investment. Further complicating matters, the level of the short rebate interest rate is not fixed, which creates uncertainty when estimating expected returns from a short strategy. Short-selling managers must also face the risk of unlimited losses. Since the price of a stock can rise infinitely, there is no limit on the loss incurred from . an upward move in stock price. Finally, losses on a short position increase the portfolio exposure to that position, while gains on a short position decrease portfolio exposure to that position.

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