Tuesday, August 18, 2009

Dedicated short-bias hedge funds - a sober look

A couple of years ago an article appeared on Seeking Alpha by Christopher Holt called Short-Bias Hedge Fund Managers: Masochists or Yeomen? Here is an excerpt:
For the past 20 years, managing a short-bias or short-only hedge fund has been a little like one of the stunts performed by street magician and certified masochist David Blaine. Like Blaine, short-only fund managers have voluntarily put themselves in highly uncomfortable, cramped, painful situations in pursuit of their mysterious craft.
Aside from those who await the arrival of a much-anticipated alien invasion and subsequent collapse of society, many short-bias managers are in the game for the right reason: alpha. In fact, some research has shown that while short-bias funds fight a constant uphill battle, they are actually quite adept at producing alpha. In other words, they lose less than one would expect them to lose (like Blaine only falling into a coma, rather than dying during one of his stunts - a stunning success!).

The article was promptly followed up by a single and direct comment from Jim Glazen: "you're a moron."

Well at the risk of getting another strong comment from Jim Glazen, it's worth taking another look at Dedicated short-bias hedge funds. As of July-09 here is what the performance of the various hedge fund strategies looks like (from CS/Tremont):

Most hedge fund strategies are down for the past year, but up year to date - some are doing really well this year. Short-bias fund performance clearly stands out. The strategy is down for the whole year as well as year to date. In fact no matter what statistic you use, the strategy has lost money:

The one-year return statistic is particularly strange, given that the equity markets are significantly below the levels from the same time last year. Doesn't that mean that these funds should be up from the same time last year? In fact the Dedicated short strategy is down almost 18%! What happened?

The chart below compares the Dedicated short-bias strategy with the S&P500 as well as the Proshares Short ETF (ticker symbol SH) over the past couple of years.

As expected the Dedicated short-bias composite tracks SH for much of the period (they are both short US equities portfolios), but then something happens in the late summer/early fall of 08. Dedicated short-bias strategy begins to significantly lag SH. In fact if you look at the regression graph, the 9/08 point stands out:

If the hedge fund strategy continued to track the short ETF, it would be up for the year. What was it that caused such dispersion? There is some anecdotal evidence that many short biased funds shorted financials during the summer of 08 - which was a good thing for them. They started doing well, but there was a "head-fake" rally as some thought a government action may stabilize the banks.

Feeling a bit of pain from the rally, some short-bias funds took profits to get out of what they thought may be a market recovery. It's easy to spot the mistake now, but at the time some of these funds were up for the year and they didn't want to risk it. Many now had a bunch of cash, going into the crash - so much cash that they ended up underperforming SH by a large margin. The SEC action to restrict shorts later did not help matters either.

Late last year or early this year, some reloaded on their shorts going into an actual rally in 09.

Bad timing seems to be the key reason for the underperformance relative to SH, and being short made these funds lose money this year. For many, it will be tough to continue marketing their funds going forward as investors will undoubtedly question the value they are providing. But as Christopher Holt points out, they can always discuss their great historical alpha.

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