Why Lansdowne may have picked a bad time to quit the short game
London hedge fund said last week that it would shut flagship long/short strategy
Hedge fund Lansdowne Partners has made a big call on the outlook for stock markets by stopping short-selling in its flagship $2.8bn fund. It may be throwing in the towel at the wrong moment — just as opportunities are finally picking up again.
Few would pretend that life has been easy over the past decade for short-selling hedge funds, which borrow shares and then sell them, hoping to buy them back at a lower price.
Trillions of dollars of central-bank stimulus has lifted prices of assets across the board. Companies that might otherwise have gone bust have instead benefited from very cheap financing, making it hard for managers to pick out the next bankruptcy or to bet against overpriced stocks. “Going short on valuation grounds isn’t working”, said David Miller, investment director at Quilter Cheviot.
Last year Lansdowne, which is one of London’s oldest hedge funds, told investors that since the global financial crisis its short positions had not beaten the market in aggregate. In other words, it might as well not have bothered putting the bets on.
But some industry insiders point to signs that conditions for long/short strategies are improving.
Equity market volatility, which for so long has remained stubbornly low, seems to have settled higher in the wake of the sharp sell-off in March. Unlike after past spikes, such as February 2018 or the fourth quarter of that year, the Vix volatility index — known as Wall Street’s “fear gauge” — has not dropped back below 20.
That should throw up more opportunities for traders trying to pick out losing stocks at more favourable prices, said New York-based Dixon Boardman, an industry veteran who set up his firm Optima Fund Management in 1988, when hedge funds were in their infancy.
“Things tend to get overdone on the way up and the way down. Volatility should enable good short-sellers to take advantage of that,” said Mr Boardman, adding that he was starting to see hedge funds make money from shorting again.
Moreover, while the coronavirus crisis has prompted emergency interventions from central banks and governments, it is also heaping pressure on already-threatened business models.
Part of the reason given by Lansdowne’s Peter Davies for stopping shorting was that if the Covid-19 shock does not expose dud companies, then what will? “Although economic recovery from recent events is unlikely to be linear, it is hard to imagine operating conditions which will stress business-models more than those witnessed in recent months,” he wrote.
However, there has already been a noticeable pick-up in corporate defaults this year. Some commentators think the trend could accelerate “as blanket [government] backstops give way to more targeted policy measures and businesses with no viable futures default and restructure,” in the words of Oxford Economics.
One of the best examples of short-sellers picking out a dubious business model came last month, when a number of hedge funds made more than €1bn in a week betting against German fintech Wirecard.
Among those profiting was Mayfair-based hedge fund EOF Partners, which uses forensic accounting to unearth short ideas. It put on its bet when Wirecard’s shares traded at about €120 and covered it at €2.25, according to an investor letter seen by the Financial Times — a 98 per cent return before fees.
And even if funds do not latch on to outright fraud, there now seems plenty of potential for traders to profit from over- and underpriced stocks. According to Morgan Stanley, the gap in valuations between cheap and expensive stocks is at levels last seen at the height of the tech, media and telecoms bubble two decades ago.
“If the market becomes more discerning about valuations, that’s good for short-sellers,” said Fiona Frick, chief executive of investment firm Unigestion.
While Lansdowne may have thrown in the towel, enthusiasm for shorting is undimmed elsewhere. As soon as short-selling bans expired in six European countries in May, funds such as Citadel and Millennium piled in to short bets.
Some funds are already making decent returns, including Chicago-based Balyasny Asset Management, up about 15 per cent so far this year in one of its funds, according to a person familiar with its figures. Others recording gains include Delbrook Capital, a Vancouver-based fund focused on commodity stocks, according to an investor letter, and Barry Norris, chief investment officer at Argonaut Capital.
It may seem odd to suggest that short selling could be on its way back after US stocks just notched their best quarter since 1998.
However, Optima’s Mr Boardman reminisces about the bull market of the 1990s, when stocks rose sharply but short-sellers still profited. “By and large, good companies went up, and bad companies went down.”