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!)