Value of Short Selling Skill Set
Shorting is an integral part of the equity long/short strategy, and I’ve heard most managers generate negligible to even negative alpha on the short side, so why don’t we hear more about short-focused analysts/PMs?
Short selling strikes me as a very useful and underappreciated skill set, as well as an interesting area to focus as shorting is more difficult than long investing (=less competition for seats). Despite that the strategy is "long/short", i'm surprised that everyone is (predominantly) focused on longs. should go without saying a properly executed short book enables the fund to go more long at reduced correlation and volatility
So, how many long/short funds have short-focused analysts? Where are short-focused analysts more popular (ex. large single managers, tiger cubs, mm, etc.)? At top single managers, to what extent are the long and short sides of the book separated?
I’m interested in whatever (qualified) other thoughts you have about the value of the short selling skill set.
Thanks very much.
I have experience working at a single manager HF with an individual very good at opportunistic equity / credit shorts.
Shorting is really, really hard. It probably can't be said enough, and in my experience most people just generally aren't too good at it. The most important thing with short selling is timing. When you own a stock or bond long you generally get paid a form of carry via dividend or coupon, and it is the opposite for shorting. In addition to the cost you pay to borrow the security, you are also on the hook to pay the dividend or coupon of the security you borrowed. This negative carry is expensive, and it eats into your P&L every day you hold the security short. Because of this, timing makes or break a good short. You might be right over the long run, but the investment will never work out because by the time the security loses price your P&L has been eaten up by negative carry. Any good short seller will have a very disciplined approach to structuring the trade around timing catalysts for price action. Part of the discipline is knowing when to admit you're wrong and cover. "Thesis creep" is dangerous for shorts.
That said, being good at short selling is a valuable skill set. There is a meaningful difference between thinking a company is bad / should be underweight vs. recommending as a short which I don't think is appreciated enough. The best short sellers I've met approach things from a credit perspective. I.e., they're only shorting a security when a potential credit event is on the horizon the market hasn't seemed to fully appreciate. I've never met a successful short seller who shorts based on valuation alone. And in fact some of the best short candidates are those that screen well based on low multiples. So you tend to find very analytical, financial statement focused individuals doing a lot of shorting.
There are several reasons why you don't see more short-focused funds or short-only analysts. Biggest reason is, again, shorting is very hard and generally doesn't always work out. The market tends to go up over time, not down. This makes shorting an opportunistic strategy that always isn't available, and while it is an important skill to have in your tool kit, I don't think it is something that will always be present in a portfolio. Note: I'm not speaking about long/short, market neutral funds who will always have shorts on to counter long exposure (and it'd be great if some of those guys could chime in here for their perspective too). This makes is hard to scale up a short-focused fund because it is hard to put all of that money to work. LPs are also aware of this dynamic, and short-focused funds usually comprise a small part of their allocation as a tail hedge-type of thing. Think of Jim Chanos' fund. Ideally, he should underperform the market during the ups but outperform during the downs which is what his LPs pay for, but no one is making Jim Chanos a core allocation.
Another point to keep in mind is that the P&L profile of even the most successful short is always capped at a gross 100% gain before carry, while the most successful long can go up to infinity. With the exception of par credits, the risk / reward profile of shorting is always skewed against you. This means that even the most successful short won't make a fund a lot of money unless it is a leveraged bet using derivatives, or just a highly concentrated position which most shorts aren't. People are thrilled to cover shorts on a single 5-10% dip because it's generally uncorrelated, as you mentioned in the OP.
There are several short-only or short-biased funds out there, and places like Third Point employ a short-only team. I think that, generally, these are seats that are great to get a couple years experience in, but I don't think anyone would have much fun trying to make a career out of being a short only analyst or PM. The short funds you need to watch out for are those who "act as their own catalyst" by releasing public reports and antagonizing companies. It's not that I have anything against the practice of doing that, but in my experience of reviewing the work of some of these funds I've often found sloppy analysis or just flat out inaccurate statements.
Valuable contribution, thank you.
What do you think of Spitznagel and his fund?
Spitznagel does tail hedging w/ otm puts. What's the connection?
Do you know of other large single managers, besides third point, employing a short-only team? Thanks.
Exhibit A - Citron (re: act as their own catalyst) and to lesser extent, Spruce Point
Thank you, super helpful. Could you comment your take on whether COVID (moves like ZM, DDOG, PTON, FSLY of the likes) has created more short opportunities because over-enthusiasm about prospect of these tailwinded names?
I don't really follow these names specifically (despite being an avid Peloton rider, myself), but I have the scars to prove I've attempted to short companies like this myself. Huge multiple, super fast stock run up, earnings which may or may not have been growing, etc - they sure seem like good short candidates. In my experience, these are the types of businesses you want to avoid trying to short unless you have a very compelling reason why. These are fast moving, market sentiment names, and it takes something big to change the "story". If you think you can time that, sure, try to short it. But as I said above, timing is very important still. You can do a lot of proprietary channel checking and conclude that Company A is going to significantly miss earnings on what was circled by the market as a critical point of the "show me" story, which could mean you go short into earnings...but, if it doesn't work you need to be willing to cover immediately or else suffer thesis creep via whatever spin the management team tries to put on the miss which is surely BS. The market might just eat that up. The number one thing I've gotten wrong with shorting companies like this, which are often tech companies, was misinterpreting the huge multiple as over valuation rather than understanding that said Company was likely right on the cusp of their "S" curve (critical mass, breakeven with huge operating leverage, etc.), and the forward multiple was actually quite reasonable if you thought the market was even soft on earnings 1 or 2 years out. Story stocks are very hard to break, but they are even harder to break if the businesses still have liquidity runway and access to capital (either via cash flow or market raising). Take a business that has a promotional CEO and can be described as a "show me" stock...that burns cash flow, but thus far has been able to keep itself alive by various capital raises...it could be a great short to identify that one earnings where the wheels start to fall off the story, and the market actually clues into the fact this is a cash burning business that now has the usual capital providers asking questions. Either 1) no one is going to give you liquidity and you die, or 2) you will get your liquidity, but at a cost of capital that rips your eyes out...both instances usually lead to some pretty serious multiples compression and existing shareholders suffer.
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Well put - I glossed over this in my comment. But basically you have a lot more relative shorts than absolute shorts in market neutral low net low vol model.
On many it’s basically just a forceranking in some valuation or other set of criteria, adjusted as needed for factor risks and the the bottom half of the lists are your shorts.
No experience on short side myself, but would add one point that seems true from a LP perspective - in this day and age, having a "one stop shop" for both long and short exposure is probably somewhat less valuable than it once was. If you want to dampen the vol you are getting from your cream-of-the-crop L/O manager, you can either allocate to a different short-only HF (dying breed, but Kynikos Ursa fund for example) or (and I think this is more of a change from prior years) use cheap factor-driven ETFs, etc. to hedge out beta.
I’ve done some time in multimanager l/s market neutral and traditional long-biased long short funds and some work with a short-only team. At all of these I’ve spent probably 75%-85% of my time on shorts and have always gravitated to it.
I feel like it’s so much easier to disprove the bull case (shorts) than to “dream the dream” on longs. To me investing is about finding misperceptions and all the incentives for all market participants are to obfuscate the downside and highlight the bull case. I feel that try to find those obfuscations in the way mgmt says things and presents numbers and the let those obfuscations guide to whatever they’re trying to hide - sometimes I think this leads to a silver bullet type finding that I haven’t experienced nearly as much for longs.
Timing is extremely important. And in the 2020 environment with implicit central bank backing of everything and little to no relationship between reality and stock prices, it’s even harder than normal.
My favorite shorts are frauds or scams... I do admit if I’m shorting a company that’s just like, facing a cyclical peak or new competition but aren’t really bad actors, there’s a little bit of a weird feeling for me to be basically aligned with their misfortune. But in those kinds of cases, what’s happening is happening and my short isn’t really that impacts their fundamentals or materially their access to capital. At the multimanagers specifically I found it weird as a sector focused analyst that often mgmt could tell from my questions or were told by someone else that I was short and that made meetings uncomfortable. I got pretty good at being vague, but it’s hard to get the questions you need answered answered, while trying to pretend you’re a happy bull unaware of the fatal business problems you’re trying to ask about.
This is just random reflections with no real point. I love short selling, but it’s hard and stressful and uncomfortable. Just like hedge funds in general
Management should be happy to converse with the bears, or else how would they know where they need to act better.
There was an article from Maverick Capital a few years back saying “short sellers are the only guaranteed buyers in the market”, puts an interesting angle to it.
SHOULD is the key word here I think
In my experience, the worse the company or situation the more they don’t want to engage with bears. Perhaps it’s different at multimanagers cause one bear could influence the other pods which may share the meeting. Even when they’re happy to engage with bears - I just think it’s uncomfortable especially when the company is F’d through no fault of their own. When management of a sinking ship has to sit across the table and say it’s not really sinking that bad - but he know it and I know and he knows I know.... just subjectively it’s feels weird.
Reminds me of the guys who 'predicted' 2009 but have predicted 27 of the last 2 crashes.
Could you clarify what part of long/short equity short selling exactly reminds you of “the guys “ that predicted the 2009 market crash?
Fundamental short-selling on individual securities is different from what you are referring to and the hit-rate is significantly higher than 2 out of 27.
He said 27 out of 2, aka they predict a crash every 6 months and a broken clock is still right twice a day, etc.
tldr: at the gates of heaven, you will be rewarded yet while in earth you will probably be underpaid.
Unless you work at a factor neutral fund, your hedge fund is compensated based on profit dollars and not factor-hedged / beta-hedged dollars. This is, of course, really silly, but it is how hedge funds work except at Citadel and a few other places. Because (I) markets are efficient, (ii) markets go up, you are unlikely to have any statistically contribution to dollar PnL unless you are lucky. As a result, you aren’t compensated for skill as a short seller.
this mostly applies to my experience working at a single manager fund. The incentives reward a positively factor loaded portfolio weighted towards tech because these models make factor exposure free. If these funds acted like factors (like equity beta) existed, it would be clear that they are a scam. As a result, they act like beta does not exist in evaluating performance.
you’re probably disappointed by me saying this. Sorry! But go work for a fund that is factor hedged if you’d like to be compensated for reducing systematic risk.
Because short selling does not produce profit dollars even when it creates alpha dollars, it is a valuable skill for funds to hire for. The reason is because they can underpay you since (after all) you generate limited profit dollars for the firm as a short selling focused analyst. The people that hire you will focus on what generates PnL while you do the right thing while being (probably) underpaid.
I think is too simplistic. While traditional single manager l/s collect fees based on profit dollars many allocate the bonuses based on alpha dollars, or other more nuanced structures. But you’re right a short position can serve its purpose in the book, underperforming and thus funding longs and downside protection while losing absolute dollars. Any manager who looks at their short book as a drag or a cost center just because it’s lost absolute dollars in peak bull market is thinking way too simplistically.
I agree with you - it's simplistic, but what I'm describing is how most of the industry works.
the reality is that the "20" in the "2 and 20" model used by most single manager funds is calculated as a percentage of absolute dollar returns irrespective of what risk was taken to generate those dollars of returns. i'm sure people will tell you that you'll ultimately be compensated in a fair way, but people say a lot of things they don't mean in order to sound reasonable. what's set in stone is the fee structure for the fund itself and generally speaking most funds do not have the structure you are talking about even if they should (why don't they? because for many/most funds they would have negative alpha dollars!)
anchor, the only reason why the world doesn't work the way you are saying is that in practice it is not possible to have a single definition of beta that the world can agree upon. even if you think the only relevant factor exposure is equity market risk, do you use daily beta over 1 year, weekly beta over 5 years? do you use a beta of 1 on everything? do you adjust this number if it is a foreign company? if so how? what do you do if the beta suddenly changed because of the coronavirus...? are you going to winsorize or clamp the betas so they are between 0.5 and 1.5? what do you do if the beta is negative for an erroneous reason? what if leverage suddenly changes halfway through the period but you are using the observed beta with a 5 year lookback? what do you do if there is M&A rumors that skew the returns? what do you do if there is a spin? what if the beta is skewed by massive earnings / drug approval news?
I’m not saying there’s a perfect way to do it. Only that everywhere I’ve seen, above very junior analysts, while the size of the bonus pool may be based on absolute PNL, splits from that pool are usually based on something formulaic that is intended to at least incentivize the team to work on shorts as well as longs. There is no perfect attribution formula, but you can still make adjustments to simple PNL in a transparent way. And SM funds often have a qualitative portion of the bonus pool through which aberrations or other performance not reflected by whatever formula can be negotiated or worked out.
I interned for a prominent short seller, very hard to do but if you understand the process and details of what goes into shorting like accounting (deciphering Adjusted EBITDA, combing through the footnotes) that skill set in itself is extremely valuable for any type of investing.
Ackman was totally right about Herbalife but sometimes things just work against you because of so many factors. I’ve had shorts go sour because I was betting against bubbles ex: Canadian marijuana, but I’ve also been extremely licking with some shorts due to Covid and geopolitical events.
Look at Muddy Waters $GSX - thesis is absolutely correct, but it’s so hard when you’re competing against big money. Nevertheless, the skills in accounting, learning about the economics of an industry help out a lot when you’re going long on a stock.
If I’m not mistaken, Buffett never had shorted a stock.
Secondly, short sellers haven’t been making any money in the last 10 years given MMT - just an example of how major forces outside of your control can hurt you big time, especially if you’re retail.
Agreed on all - it’s a lot easier to be “right” about the earnings power of the biz vs “right” about the stock. Being right about this biz doesn’t really matter if you don’t time the perception shift and inflection well. All skill is IRR but not all IRR is skill
In my fund, each analyst is required to come up with at least one short idea (and it shouldn't be a pair trade)... it's not natural, but it builds discipline.
Building habits to think from the short-selling side, it actually makes me a better long idea picker. It trains me to stay objective with my core long ideas as I am 100% aware of the fact that there are definitely many short-selling counterparts against my long thesis.
This is a very good point. I was a dedicated short seller at the beginning of my HF career. It's tough but it really makes you much much more independent when thinking about investments. Drown out sellside noise, buyside noise, management team fluff. I think short selling is the pinnacle of public market investing. It's tough to do. But ppl are ALWAYS looking for someone with a solid short pitch and with a strong skillset in shorting.
Short sellers are able to piss off Elon Musk like no other so there’s that.
Based on my experience, and in addition to timing of entry, you have to be very disciplined about covering. I find shorting as a primary investment strategy to be irreplicable in generating sustained alpha. I use it mostly to hedge an otherwise long book or make sure there's another long leg of the trade to offset the neg carry on a (credit) short thesis.
Short selling is significantly harder than the long side because you don’t get the benefit of risk premiums. Also, operationally it’s more difficult to short a stock than buy.
However, I'm curious about how you define generating alpha as a short seller. My opinion is that if the market is up 7% on average and your short book does better than losing 2% annually, I'm highly interested. Basically, if your return is better than inverse S&P500 plus 5%.
As a stressed/distressed credit guy, I've found an understanding and implementation of shorts to be paramount to being able to be long a stressed credit. If you don't understand why something can crack at par, you won't understand why to be long something in the 70s/80s.
That being said, implementing real alpha shorts is incredibly hard and the opportunity may only come around 1-2x a year in credit if you're lucky. More often than not it will run against you, but if you can find a real short you're making 20-40%.
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