A Shortage of Shorts?

130/30 08 Nov 2007

With 1X0/X0 strategies pegged to draw in trillions over the next decade, the sticky question of the potential market impact was top of mind today in New York at a conference focused on portable alpha and 130/30 strategies.  Participants ruminated on portable alpha yesterday.  Today was all 130/30.

With the short selling required for 130/30, the 800 pound gorilla in the room was the finite supply of stock actually available to borrow.  In a posting last fall, we discussed a report by Goldman Sachs on this topic (see related posting).  Speakers here seem to share our skepticism about whether this posed an immediate problem.

However, many weren’t so sanguine about the longer term.  I asked Deutsche Bank’s Brian Bausano, Co-head of Global Prime Finance for the firm, whether there would someday be a “shortage of shorts”.  He replied that, notwithstanding today’s huge excess borrow capacity, potential shortages would be “non-linear” and would likely occur in certain parts of the market first.  For example, he suggested that borrow shortages would likely show up in small-cap names first since small cap names are more likely to be shorted by 130/30 managers and since there is simply less stock available in these names.

(130/30 managers are more likely to short smaller-cap stocks since they can effectively express a negative view on a large cap by simply weighting it at 0%.  Small caps, however, represent a tiny portion of the index.  So a zero-weight amounts to only a minor bet against the stock.  Therefore, expressing negative views on small caps requires more short-selling.)

Goldman Sach’s MD Ingrid Tierens provided some interesting new data on this issue.  She reported that around 23% of the float of all US equities is currently available to borrow (vs. several percent that is currently on loan).  For Western European countries, the available borrow was between 10% and 15%.  Oddly, Canada, a country with a relatively mature short-selling infrastructure, had an available borrow of only around 7-8% of total float according to the research.

Tieren’s data also showed that the average percentage of float available for lending was around 20% (globally), but was quite evenly spread between 1% and around 35%. While the average borrow cost for a Russell 1000 stock was only slightly higher than a baseline of “easy-to-borrow” stocks, the borrow cost for the average Russell 2000 stock recently peaked at around 3x that figure – up from only 2x higher as recently as February 2007 (i.e. the second 1000 of the R2000 had a borrow cost around 6x that of the baseline “easy-to-borrow” stock.)

One would expect that a rising borrow cost may have been caused by a lack of borrow availability.  Yet Tieren’s data also showed that the proportion of “not-easy-to-borrow” stocks has actually fallen since February 2007.

In an attempt to get my head around the confusing and famously opaque stock lending market, I asked Josh Galper of Vodia Group, a research firm serving the brokerage and asset management community, about the linkage – if any – between the cost to borrow a stock and the price of the same stock in the cash equity market.  Galper acknowledged that today these markets seem to operate in two separate worlds, with a very weak linkage.

Tastes Great!…Less Filling!

Another major theme running its way through the discussion today was the dissonance between theory and human behavior.  A panel focused on comparing portable alpha and 130/30 seemed to conclude that, while both strategies may have a very similar theoretical rationale (beta plus alpha), investors simply did not view them as being cut from the same cloth.

One speaker, a pension manager using a 130/30 approach, was asked why he did not simply invest in hedge funds if he was such an advocate of removing investment constraints (e.g. the “long-only constraint”).  In response, he listed various common issues with hedge funds from “headline risk” to a lack of transparency.  In other words, he may well have agreed with the questioner, but acknowledged the behavioral reality of the situation.

“Quant vs. Fundamental” cage match

The question of who was best qualified to execute a 1X0/X0 strategy, “quants” or “fundamental managers” also permeated the dialogue.  Alpha Equity’s Charles Krusen predicted that the quant/fundamental split will move from around 85/15 today to 60/40 in the years to come.

Co-panelist Robert Weigand, a professor at Washburn University School of Business said the early lead enjoyed by quant managers was a result of pre-existing short ideas and prime brokerage relationships.

Weigand also argued that 130/30 is a natural response to a compression in security return dispersions earlier this decade:

“It makes a lot of sense that this product [130/30] was introduced when it did…because there is always an average market return. But within an index there is a dispersion of security returns around that average.  Starting at the turn of the century, there was almost an unprecedented compression of that return dispersion that…put another pressure on long-only managers to deliver alpha from stock picking when there was much less dispersion of return in whatever index you’re benchmarking to.  So when you short-sell and lever-up your long positions you are using leverage to re-establish that former spread of returns.”

130/30 Fees – Making ’em up as they go

130/30 fees were also on everyone’s minds today.  Wilshire’s Florian Weber said that the pricing scheme used by many early entrants – charging a multiple of long-only fees based on gross exposure (i.e. 160%) – has recently given way to fees that were slightly lower than this.  Other participants said that there was still no emerging standard or consensus and that 130/30 fees charged by hedge fund managers remained significantly higher than those charged by traditional managers.

Sapra (of NFL fame) on the optimal “X” in 1X0/X0

The “anchorman” on today’s agenda was Analytic Investors’ Steven Sapra.  According to some experts, Analytic actually invented 1X0/X0 investing (see related posting) and Sapra is the co-author of a recent paper on the optimal “X” in 1X0/X0 (see related posting).  If you’re a US sports fan, check-out Sapra’s article on alpha in the NFL (see related posting).

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