Short Selling: The Best Kept Secret (?)

A certain venerable gentleman (and scholar) claims to have found the “best kept secret of short selling”. What is he referring to? Is he right?

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Short Selling Funds are frauds and an embarrassment to the industry – according to a “John Doe”

A friend – I will refer to him as “John Doe” – known for cautioning against short selling over the last 1-2 years – escalated his rhetoric yesterday with the following claims:

  • “The success of shorting as a strategy is evident here”, referring to a diagram showing the # of short funds flat between 2007-2016.
  • “shorting as a strategy is the same kind of fraud that they claim to sniff out. Glad market sees it.”
  • “it’s a pipe dream that has a shelf life of a Twinkie.”
  • “There isn’t one short fund there w compounded long term double digit returns.”
  • “Because since shorting doesn’t actually make any money I consider anyone who does it for a living an embarrassment to the industry.”

Are the above claims true? Here’s what I believe:

  • “The success of shorting as a strategy is evident here” MOSTLY TRUE
  • “shorting as a strategy is the same kind of fraud that they claim to sniff out. Glad market sees it.” FALSE
  • “it’s a pipe dream that has a shelf life of a Twinkie.” TECHNICALLY TRUE, BUT IRRELEVANT
  • “There isn’t one short fund there w compounded long term double digit returns.” DEBATABLE
  • “Because since shorting doesn’t actually make any money I consider anyone who does it for a living an embarrassment to the industry.” I VEHEMENTLY DISAGREE

Let’s examine each claim, one by one:

“The success of shorting as a strategy is evident here” – MOSTLY TRUE

John Doe sarcastically wrote “The success of shorting as a strategy is evident here” in response to the following tweet:

John Doe is correct in implying that short selling – as a business – has been terrible (a fact, that is very well known among short sellers!).  However, I would not use HFR data as the basis of your argument. I can tell you firsthand that these data sets are quite imperfect (to put it politely). There is far superior supporting evidence, to the assertion that short selling has been terrible business:

  • Aggregate returns have been terrible (if not beyond terrible) in the above-mentioned time period.
  • The number of funds has remained flat (if not declined) between 2007 – 2016, despite hedge fund assets under management increasing 2x (if not more) during that time period. So actually, the effective allocation has declined by at least 50% since 2007!

There are some historically unprecedented reasons (post 2008) why short selling has been a terrible business. But no excuses, John Doe is correct: short selling business has been particularly bad business in recent years.

“Shorting as a strategy is the same kind of fraud that they claim to sniff out. Glad market sees it.” FALSE

The above claim that “shorting as a strategy is a fraud” goes beyond his usual “short selling is dangerous” rants (which I generally find to be well-intended and in the public interest, for the simple reason that short selling is so difficult).

I find John Doe’s claim false for the following reasons:

  • I am not aware of a single short fund that has been accused of fraud; nor am I aware of any that has ever committed fraud. I can assure you, however, that there has been fraud in the rest of the industry. Seeing that the rest of the industry currently constitutes 99.99% of the assets under management, it seems highly reckless (not to mention inaccurate) to allege fraud in the 0.01% minority, while there’s plenty of actual fraud within the 99.99%.
  • Of the few short funds that do exist, most historically do not claim to “sniff out fraud”. The short sellers who publicly sniff out fraud are a fraction of that tiny 0.01%. Even among those who publicly sniff out fraud, a large % of their books tend to be shorts they believe are structurally poor businesses, not frauds. Yes, their returns have been poor, but failure is not fraud. So let’s suppose John Doe were correct that short sellers who sniff out fraud, are frauds themselves. That would be inapplicable to the majority of assets dedicated to short selling. That is, his claim  would be substantially false because it would be inapplicable to the vast majority of money dedicated to short selling.

“it’s a pipe dream that has a shelf life of a Twinkie.” TECHNICALLY TRUE, BUT IRRELEVANT

It is a fact that short funds have a high mortality rate (“a shelf life of a Twinkie”), and die at a young age…just as hedge funds do in general:

Most hedge funds fail: their average life span is about five years. Out of an estimated seventy-two hundred hedge funds in existence at the end of 2010, seven hundred and seventy-five failed or closed in 2011, as did eight hundred and seventy-three in 2012, and nine hundred and four in 2013. This implies that, within three years, around a third of all funds disappeared. The over-all number did not decrease, however, because hope springs eternal, and new funds are constantly being launched.

source: https://ftalphaville.ft.com/2014/07/31/1913792/most-hedge-funds-fail/

So yes, short funds are hedge funds. Hedge funds die young. So what’s your point, John Doe (unless you’re alleging that short funds’ life span is dramatically even shorter than the already short 3-5 year life expectancy of all hedge funds!)

“There isn’t one short fund there w compounded long term double digit returns.” DEBATABLE

If John Doe is claiming that none of the short funds within that HFR sample can boast of a long term double digit returns…I am inclined to agree. However, I know for a fact that there have been at least three short funds that were able to boast of long term double digit returns – Rocker Partners, Water Street Capital, and the Feshbach Brothers’ fund(s). So if he is claiming that it cannot be done? I think that is simply not true.

“Because since shorting doesn’t actually make any money I consider anyone who does it for a living an embarrassment to the industry.” I VEHEMENTLY DISAGREE

I know people who have made money via short selling, so if the John Doe’s logic is:

If “one does not make money” , –> then “one is an embarrassment to the industry”.

and if there are short sellers who have and do make money…that would seriously undermine the John Doe’s “reasoning”.

There have been far richer hedge fund managers who have made a variation of the above argument: “where are the billionaires who made their money via short selling?” i.e., therefore short selling is a waste of time, waste of money.

At face value, the above is an excellent point: short selling is not the path to riches. I am not aware of a single billionaire – in the world – who made their money solely short stocks.

But it is my opinion that the above thought process misses the point.

Closing Thoughts

I personally like John Doe and believe that the vast majority of his tweets about short selling are not only true, but practically helpful to people in the business. I happen to agree with his bottom-line: most stock pickers in the hedge fund industry should not short stocks (in turn, their investors should also pay them far less, and/or purely on profits).

In this piece, I evaluated the merits of his claims (in this case, the lack of merit to his claims) on their own feet. Truth stands on its own feet. Is it possible that he believes and/or is propagating false claims for other motives?

Perhaps John Doe feels threatened by fund managers with short selling prowess, when it comes to the business of raising money. It is my understanding that John Doe had a good/great 2016, performance wise, and that he has attracted some outside money recently (and is looking to attract more money. Kudos to him).

When asked why should he care about short selling funds, John Doe clearly acknowledged that he sees them as competition for raising money. That is puzzling to me; if short selling funds don’t make any money, and John Doe is “glad market sees that”…lol, why and how are we your competition?

Maybe he feels threatened because the truth hurts; I know people deploying similar/greater amounts of money as John Doe, who had a similar/better year in 2016 than John Doe did…purely by shorting stocks. It is my understanding John Doe is a long only, with a concentrated portfolio of stocks. So this means that these people I know not only generated similar/better returns in 2016 as John Doe…their alpha was significantly higher. Imagine that.

I will close with two thoughts:

  • Why is it that a good number of high performing hedge fund managers (with great long term track records) vehemently disagree with John Doe? 
  • The markets humble all. (I seem to get humbled by the markets at least once a year!)

The Limitations (?) of Non-Discretionary Trading

Active fund management continues its decline (both in popularity/adoption, as well as in realized performance), even as passive investing moves in the opposite direction. One needs to look no further than [aggregate] hedge fund performance in 2016. Like 2015, yes, you had some notably good performers…only to be offset by notably poor performers.

Concurrently, “quantitative investment management” (which I prefer calling “non-discretionary trading”) remains in vogue. Look no further than the assets under management of AQR and the likes, of the world… or the political influence of Renaissance Technologies (though, in fairness, Rentech has been anything but an ‘asset gatherer’).

Question: What effect – if any – do the simultaneous popularity/success of ‘passive investing’ AND ‘quantitative investment management” today have on their future returns/losses (and the smoothness/volatility of those returns/losses) ?

Let’s oversimplify and say that the ‘alpha’ of the non discretionary participants arise 100% out of the discretionary active participants. If the actives are being pushed out because of both the passive AND quantitative trends… does that not diminish the alpha opportunity set for the non discretionarys? What if I were tell you that some of these non discretionarys use 10x-20x leverage…on their equities books?

Some of you may recall the “great quant meltdown of [August] 2007”, that occurred just under 10 years ago.Seemingly invincible quant funds experienced sudden and meaningful declines (e.g. -5 to -30%).

The likes of Soros, Druckenmiller, Paulson, etc… all great wealth compounders for themselves AND outside investors – eventually experienced real/meaningful drawdowns/losses.

Given that the capital flows towards passive and quant have largely occurred at the expense of active management… i.e., as passive and/or quant become more ‘crowded’ … are they truly immune to what the likes of Soros/Druckenmiller/Paulson all eventually experienced?

I think not.

ADDENDUM on 1/9/2017

Perhaps quant alpha now and in the future, just might (also) be derived from the negative alpha of other quants. For example:
BlackRock Quants Sustain Record Losses in Setback to Fink Plan

BlackRock’s main quantitative hedge-fund strategies — which use computer models to sort through vast amounts of data to pick out patterns — were on track for losses in 2016, according to a monthly client update sent out in late December. Of the five included, four were set for their worst returns on record, data through November showed.

I don’t what the sources of the losses were..but it is a possibility worth entertaining.

 

Things that make you go ? as we enter 2017

The year is more or less over. As we head into 2017, here are a few things that make you go ?:

  1. “Hey brother @realDonaldTrump give me control of the Fed and we will make the economy great again. Dow at 40k in 4 Years. #Yeswecanseco” – December 11th https://twitter.com/JoseCanseco/status/808172792688439297
  2. “GET READY FOR DOW 20,000” – Barron’s front page, December 12th
  3. “The US dollar is on fire” – December 15h http://www.businessinsider.com/us-dollar-market-update-december-15-2016-2016-12
  4. “Outlook 2017: This Bull Market Has Legs” (10/10 strategists say market will be up) – Barron’s front page, December 17th
  5. “An economist who predicted a 17,000-point stock-market crash just 10 days ago is suddenly bullish” – December 19th http://markets.businessinsider.com/news/stocks/An-economist-who-predicted-a-17-000-point-stock-market-crash-just-10-days-ago-is-suddenly-bullish-1001616771
  6. “After peaking at $554 million in February, assets in bearish Rydex funds have dropped 75%, nearly the lowest in 20 years.” December 20th https://twitter.com/sentimentrader/status/811281760512339968 12/20
  7. Plenty of chatter, in recent days, about funds up 30%-40%+ YTD.
  8. “Gartman says stocks going higher” – today
  9. Gartman on the $: “the dollar is headed higher, dramatically so” – today
  10. “Jim Cramer’s flashing signal that the massive rally is here to stay” -today http://www.cnbc.com/2016/12/21/cramers-flashing-signal-that-the-massive-rally-is-here-to-stay.html
  11. etc

Interpret at will.

Theranos (i.e. Therafraud) Full Complaint

 

theranos-complaint

Finishing 2016…and a Sneak Preview of 2017

It’s been just over 10 days since the US Presidential election, and I sense that many Americans – and market participants – are still in a state of “denial or anger”. That said, some people have moved on towards ‘acceptance’ (e.g. Dalio, Buffett, President Obama, etc). From my perch, it’s too early to say.

Based on public reaction, there are reasons both to be hopeful, and to be concerned (whether these hopes and concerns are meritorious or not, remains to be seen):

Reasons to be hopeful – the appointment of the likes of Jamie Dimon, Nikki Haley, Mitt Romney, etc mentioned as potential Trump Cabinet members – have given hope even to the likes of the Vox founder, a known Hillary Clinton propagandist  https://twitter.com/ezraklein/status/799369055207497728

(most of) Donald Trump’s own words – e.g. 60 minutes interview – emphasize unity, repudiation of violence, economic expansion (e.g. infrastructure spending), etc.

President Obama and Donald Trump’s public behavior towards one another has uplifted public/market confidence as well.

Reasons to be concerned – the appointment of the likes of Steve Bannon, Jeff Sessions, and Michael Flynn have caused fear in many Americans. By some measures, reported acts of violence have creeped up.

The rhetoric regarding “bringing jobs back to America” is encouraging, but it’s just that: rhetoric. What happens if rates rise in a meaningful fashion, leading to runaway inflation? Rising unemployment and inflation would be a very difficult situation – whether the Trump administration is at fault or not.

My View: Too early to say.

As it pertains to financial markets, I have observed:

  • Eye-popping exuberance in US Financials – some would say record breaking exuberance, as gauged by highest recorded RSI in the XLF ETF history. Question: have financials’ equities historically benefited during rate rise cycles? Which sectors have tended to benefit? Suffer? Why?
  • Statistically significant price movement in Government Bond Prices – “USTs yield haven’t moved this much since [20+ years ago]”
  • USD strength, EUR weakness, MXN (record weakness) – To my surprise, I heard that a large institution actually put on a long MXN USD trade, pre election, as the “long Hillary” trade. Well, we can imagine who/how has been ‘unwinding’ that position since November 8th. Also, imagine how countries with significant $-denominated debt are feeling right now? Not only has there been upward pressure on all government bond yields, world wide, but the $ strength as well. This trend cannot last indefinitely without some severe consequences.
  • Russell 2000 Longest Winning Streak for over 13 years – Some refer to this as a  “Make America Great Again” trade. What exactly is included in this Russell 2000? What are its member constituents?
  • Rumors that an “Axe Capital” peer is experiencing historic short term losses
  • Historic [by some measures] Equity Price Dispersion – Given the extreme dispersion in equity prices – historic or not – I find it ironic seeing some people say “it WILL be great for stock pickers, going forward” – how about it IS and HAS BEEN ?
  • My friend jokes that a Trump 1st term, 2nd term, and legacy now are all priced in.
  • the below is interesting, especially if you recall what happened in January/February of this year (not to say history will repeat exactly)

 

My prior posts have been helpful and remain relevant:

The 2nd Half of 2016: Nationalism & Political (In)stability – July 16, 2016

The sum result on financial markets is not immediately clear, especially as it relates to US financial markets. What is clear(er) to me is the growing importance of global macro, or at least understanding how global macro impacts one’s investment strategy. Specifically, I will be surprised if the following are NOT true, going forward:

  • (Continued) Record-breaking bi-directional macro volatility
  • Confusing, inconsistent, and sometimes outright non-sensical correlations between headline political instability/violence versus financial markets price activity

I expect the 2nd half of 2016 to continue with record breaking market activity.

 

Regime Change(s) in Financial Markets and Politics – MARCH 3, 2016

 

Politics

  • Rise of Nationalism. Pretty much everywhere.
  • Trump is winning. Bernie Sanders Super Tuesday results disappointing. The loudest Trump critics appear to misunderstand him and his fans. No matter, both point to regime change. Note that “regime change” in Asia and Europe before the modern era, were often accompanied by executions.
  • Supreme Court, replacement for Antonin Scalia.
  • Regulatory enforcement is rising (after decade-low levels of white collar fraud enforcements through 2013/2014″ e.g. Valeant Pharmaceuticals. Regime change.
  •  Europe – Brexit, Spain (Visca Catalunya), threats to Schengen, etc.
  • China – Xi regime gives off the impression of a more nationalistic tone.

 

The above lead me to believe that we are transitioning from one state to another… methinks the ‘regime change’ may resemble the transition from the dot com bubble/bust to housing bubble/bust. We’re somewhere in between two different regimes.

 

What I like entering 2017:

The short answer is, TBD; I’m not sure. That said, if I had to place all my capital into one trade for the next 12 months, there is one that comes to mind, with unlevered expected return of over 20%: it’s a quasi-arbitrage situation. It is a meaningfully sized position.

It involves going short the underlying security and long the one related to underlying one. I say quasi, because if the equity markets were to correct (or if the underlying security were to continue declining), I believe there would be a meaningful risk that the current gap (which shouldn’t exist, or at least, be this wide) widens further. But that would excite me only more.

Critiquing John Hempton’s “Comments on investment philosophy”

“There are plenty of people out there who call themselves Buffett acolytes – and as far as I can see they are all phoneys. Every last one of them.” – John Hempton circa Anno Domini 2016

I read John Hempton’s Comments on investment philosophy – part one of hopefully a few… and felt inspired to write a few disparate (potentially related) thoughts:

  • Investment Beliefs are Useless – Zen Master Linji: “If you meet the Buddha, kill the Buddha.” The Bible: “You shall have no other gods before Me.” Let the professional bullshitters worship false investment gods. I say: Investment beliefs are useless, if not worse than useless, unless you’re in the business of sounding smart, selling books, newsletters, etc. If you want to BE smart: Innovate or perish.
  • “If you know the enemy and know yourself, you need not fear the result of a hundred battles” – Like John Hempton, I read Warren Buffett’s letters when I was starting out in the investment business. Over time, I came to realize I learned far more by becoming self aware of my own tendencies, biases, mistakes, victories, good luck, bad luck, etc. rather than reading “how to invest” books. Self examination, over time, has been, and remains, a critical part of what I do… as well as observing others. Learning who I am – a short seller – changed everything. Study self, study others.
  • Poker & Transparency – I believe that the word “transparency” is frequently (i.e. more so than not) misused and abused, when used in a business and/or financial markets context. When you play poker, do you reveal your cards? Do you (intentionally) seek to reveal your emotions? No and no. In fact, it is morally and ethically correct, within the context of Poker, NOT to reveal one’s cards, nor one’s emotions. I’m a strong believer and proponent of truth and honesty.  Some people mistake the word ‘transparency’ for truth and honesty. They are not the same thing, as the poker analogy demonstrates.
  • Applied Epistemology – Deep down, I am a very lazy human being. I like to do as little work as possible while achieving superb results.  And so I am constantly asking myself: “Am I wasting my time? Given investment opportunity x, should I be spending my time on x? If yes, how much more time? Am I wasting my time?”
  • Pair Trade: Short Credentials, Long Skills/Character/Attitude 
  • Am I or Am I not Behaving like a Capital Compounding Machine? – I try to think about this daily/weekly. Is my capital and/or time dedicated to capital compounding activities or not? If not, better off just having a good time…resting/leisure time are necessary.
  • The Asset Gatherer versus the Capital Compounder – I see the Asset Gatherers as my natural enemies, my natural prey…in fact, I see it as my goal to slaughter and devour them into extinction (aside from the passive Vanguards of the world, who are NOT my enemy) . I began this business – semi-traditionally, and semi-unconventionally – as a pure capital compounder. That remains the case. When I see investment managers whose primary instinct is to be an asset gatherer, and would not be investors if it weren’t for external capital, I see tasty prey…my meat.

 

Specific Commentary (Hempton’s quotes are in bold, while my commentary is not in bold):

  • “Phoney Buffett-style value-investing is dangerous” – Not only do I believe that this is a true statement, it has been one of the main mandates of my twitter account – to ridicule and expose the Buffett idol worshippers who effectively practice this phoney buffett-style value-pretending.
  • “There are plenty of people out there who call themselves Buffett acolytes – and as far as I can see they are all phoneys.” – This is an inconvenient truth…probably offensive to some, but nevertheless true. Buffett acolytes represent a religious/cultural phenomena. In fact, let me take this one step further: today’s Buffett acolytes are probably the de facto counterparties of a young Warren Buffett.
  • “There are psychological feedback mechanisms that stop you meeting the twenty punch-card test. Firstly it is really hard to be that patient.” – I tend not to struggle with patience… I do struggle with boredom (yes, there is a difference!). How do you bide your time, while waiting for the fat pitch? Fortunately, I think I have found a few solutions.
  • “Somewhere along the line I realised that did not have the temperament to be a true 20 punch-card investor.” – This is of cardinal importance, i.e., to know thyself.
  • “And when you are wrong like that it is scarring. It makes you less willing to pull the trigger in quantity when something does meet the twenty punch-card test.” – I don’t believe this is an objectively true claim; it seems subjectively true. I personally know people who have and/or can bounce back from 20%-40% declines, without an impaired ability to ‘pull the trigger’ in quantity.
  • “So in the midst of under-performance a client might ask me what I did last year and I would say something like”
    • a) I read 57 books
      b) I read about 200 sets of financial accounts
      c) I talked to about 70 management teams and
      d) I visited Italy, the UK, Germany, France, Japan, the USA and Canada”
    • two friends of mine – (they do not know each other) strongly advise I should spend a good % of my time away from “computer screens” – go to the beach, go on vacation, etc. They advise doing this, independent of investment performance. Given my naturally lazy tendencies, I will probably heed their advice.
  • “Real twenty-punch-card investing is impossible to sell to clients” – unless the clients themselves have experience enduring/overcoming drawdowns
  • “Some of them have tricks I do not understand (I put David Tepper in this camp – I simply don’t get how he does it and hence can’t emulate it*)” – I like to study and/or interact with people like these, even if their activities do not resemble my own. I am a firm believer in “cross-pollination”
  • “Portfolio managers I admire” – I’ve tended to learn more about active portfolio/risk management from macro managers than L/S ones. I’ve tended to learn more about investment research from L/S managers.