Hedge Funds and Short Selling – Can they be blamed for the recent crisis?

On the 19th September 2008 ‘excessive’ falls in stock-markets, and particularly banks, led the Securities and Exchange Commission (SEC) in the US and Financial Services Authority (FSA) in the UK to ban short selling. Demands were also placed on Hedge Funds to disclose short positions.

The concept of short selling is alien to most. However, Hedge Funds by association with this ban have been seen by some as the cause of this crisis. This article will look at whether Hedge funds can realistically be blamed for the vast falls in the price of banks and associated financial turmoil that has ensued.

What is a Hedge Fund?

The term ‘Hedge Fund’ refers to a wide range of investment strategies, often using highly specialised proprietary tools and employing the sharpest minds in the investment industry. The use of the word ‘Hedge’ is somewhat misleading as this is only one strategy employed and refers to purchasing two different investments. The two investments are meant to offset each other – one will benefit if the price of the asset goes up, one will benefit if it falls. The overall effect is supposed to minimise risk. Hedge Funds of this type are often referred to as ‘Market Neutral’ or ‘Long/Short Bias’. Other funds employ different strategies. Some invest in ‘Distressed Securities’. This normally refers to companies that have filed for bankruptcy and the market currently undervalues their securities. Often investments of this type can yield returns to investors only after long legal proceedings. Other strategies specialise in particular geographies, sectors or asset classes e.g. ‘Emerging Markets’, ‘Agriculture’ or ‘Currency’ while others take a much wider view on Global Markets (Global Macro or Global Tactical Asset Allocation strategies).

Hedge Funds are also able to borrow money (leverage) and purchase on margin (not invest the full amount to buy an asset, instead borrowing it from another firm) to enhance their returns. The fear with this is that although gains may be magnified, so can losses. In the current market, with the difficulty of finding credit, and especially in light of the decline of Lehman Brothers, many Hedge funds have been forced to unwind their positions.

Why invest in a Hedge Fund?

With all this complexity and the vast difficulty in valuing a Hedge Fund’s investments, some may ask what is the point in investing in this asset class? The investment rationale for a Hedge Fund is simply that it provides both diversification and return enhancement benefits to investors. Returns from Hedge Funds are not necessarily correlated (move in the same direction) with traditional equity and bond investments, and so can smooth an investor’s returns and provide very high returns.

The returns on Hedge Funds can be at both ends of the financial spectrum. In December 2007 Andrew Lahde, who runs the US Residential Real Estate Hedge V Class out of California, reported a return of over 1000% on his fund in a single year following a large ‘bet’ on falls in the value of American Sub-Prime mortgages. When you compare this return to the 5% you would get in an average deposit account, the benefits become obvious.

However, at the other end of the spectrum is a series of magnificent financial failures. In August 1998 Long Term Capital Management (LTCM), who were famed for employing Nobel Prize winning economists and regularly returning close to 40% p.a., wrote a letter to their investors stating that the fund had lost close to $2.1bn (about 52%) in a single month. The fall in LTCM was largely a result of excessive leverage and borrowing.

This idea is similar to current conditions. Excessive borrowing (this time on real estate) is fundamentally the same problem as that experienced by LTCM, only on a much wider scale and with the average person having a potentially greater exposure. In this respect, it is all who have borrowed beyond their means that have driven this crisis, whether this be through credit cards, personal loans, or the more obvious sub-prime mortgages.

One of the major problems is that Hedge Funds are largely unregulated (and subsequently inaccessible for the majority of investors) and only report returns when they choose to. The consequence of this is a selection bias. Furthermore, only the best funds survive, upwardly distorting the returns for Hedge Funds as an asset class.

What is Short Selling?

Short selling involves selling an asset that you do not yet own by borrowing it from someone else temporarily (normally for a fee). While this may sound complex it is common practice within the financial world. The basic process starts with a Fund Manager believing that the value of an asset is likely to fall. This could be for a variety of reasons, including poor news, a change in the market for a product or service, or a profit warning. The fund wants to profit from this fall. What they do is find another individual who believes that the opposite will happen i.e. the price will rise. The opposite part is called a counterparty. The two parties come to an agreement between each other. The counterparty profits if the price rises and the fund benefits if the price falls.

For example:

1. A fund finds a counterparty who thinks the price will rise.
2. The fund borrows the stock from a pension fund or broker at say a price of $50.
3. The fund agrees to deliver the stock to the counterparty in 2 days time with the counterparty paying $50 (they think the price will be higher than this and so they are getting a good deal).
4. In 2 days time the price of the stock is only $30.
5. The fund delivers the stock and receives $50 from the counterparty.
6. The fund buys the stock at $30 and returns it to whom they borrowed it from.
7. The fund pockets the difference of $20 – an instant profit.

In March 2008, supposed Trashing and Cashing of HBOS shares did lead to substantial falls in the company’s stock price. This resulted in a full scale investigation and it was found that the rumours about the company were false. If the same investigation was to occur now, with the benefit of hindsight, it would be interesting to see if the same investigation still found the ‘rumours’ to be false.

So can Hedge Funds and their Short Selling habits be blamed?

Hedge Funds have been condemned for many years with the more harsh critics stating that they will be responsible for a global financial meltdown of the scale being experienced. Hedge Funds have always drawn criticism, partly due to the large sums paid to their managers. While the average manager will not earn anywhere near this sum, the declaration of a £1.9bn (that’s £1,900,000,000 a year or £216,895 per hour) personal pay package to John Paulson of Paulson & Co, following his call on the sub-prime market, was perhaps justifiably seen as excessive profiteering from others’ misfortune. It is certainly true that avarice is a fundament of the industry and hedge funds can and will continue to potentially profit from the misfortune of others.

The short-selling ban was, however, the result of Hedge Funds supposedly betting on the price of major banks falling and the force of this selling being so great that it became a self-fulfilling prophecy.

However, there are several arguments against this theory:

• Levels of short selling were so low compared to investors who were long in these stocks that the Hedge Funds could not have impacted the market.
• Similarly on the 19th September, when the ban in the UK started, the FTSE 100 stood at 5,311 and on 14th October it stood at 4,394. If Short selling is to blame, it is unlikely that this would be the case.
• Most importantly, since the ban was implemented bank shares have increased in volatility, with falls of over 40% followed by subsequent rises of 60%.
• National governments and Central Banks have been forced to launch vast re-capitalisation programmes and interest rate cuts. If Short Selling was to blame, none of this would be necessary.

Hedge Funds are, and will arguably remain, a convenient scapegoat for financial pundits. They are elitist, complex, lack transparency and thus remain an obvious target. Despite this, the role of short selling is important for both hedging risk and ensuring securities are priced at intrinsic value rather than being fuelled by over-bullish sentiment. Hedge Funds can assist in this. Ultimately, it is highly unlikely that Hedge Funds can be blamed for this crisis and particularly the excessive falls in banking shares.