Of all the investment strategies currently employed by hedge funds, none provides potential for tremendous gain (or loss) more than shorting. To be accurate, a majority of hedge funds use shorts as part of their overall strategy; however, there are three different types of hedge funds where shorts play a major role: 1) short-only hedge funds; 2) short-bias hedge funds; 3) long-short hedge funds. This article will deal with short-only and short-bias hedge funds in order to understand what shorting can add to a hedge fund's arsenal. It should also be noted that with greater innovation in the financial industry, a wider array of financial instruments has opened up new opportunities for short investors. Whereas short investors traditionally had to place positions through buying stock on margin, hedge funds can now place sophisticated shorts against equities and equities indices through derivatives (e.g. options).
There are a number of strategic advantages for equity short hedge funds. The primary advantage for short hedge funds is the opportunity to drive above average returns with contrarian bets. One of the main tenets underpinning shorting is that the market has mispriced a company's value; hedge funds then can short a stock based on the premise that the market price will decline. Many hedge fund managers drove high returns during the market volatility of 2007-2009 based on prescient shorts against market wisdom: David Einhorn of Greenlight Capital shorted a soon to be bankrupt Lehman Brothers; John Paulson shorted a soon to implode housing sector; numerous hedge funds took large short positions against banks with toxic balance sheets such as Bear Stearns, Wachovia and Citibank. These investors posted above average returns due to their foresight to short in the market and the fortitude to stick with their instincts.
Just like many other investment strategies, the weaknesses of shorting are connected to their strengths. While some investors profited handsomely from shorting the market, others posted significant losses, even to the point of liquidation. A main disadvantage of shorting is that investors can face an unlimited downside if the investment sours: Investors who short typically borrow money to buy a stock, sell it, and then gain profit by buying back the shares at a substantial discount to cover the trade. If the stock price increases between the sell and buy date, however, the fund has to cover the difference. Hedge funds that hedge against short positions somewhat limit their exposure; however, that also in many cases limits the upside.
A second main disadvantage is market architecture; that is, the market can make it difficult to scale up and exit short positions. Hedge funds typically make money through assuming concentrated positions that become profitable through ramping up scale - usually through applying leverage (borrowed money). Short positions, however, are notoriously difficult to acquire adequate scale, particularly if other funds adopt a similar position that can lead to a "crowded trade". Finally, there is significant liquidity risk in taking short positions: During the financial crisis, policymakers viewed shorting as a cause of financial volatility rather than a reaction to it. As a result, numerous governments banned short selling on exchanges. Consequently, many investors found themselves unable to get into new, profitable short positions.
In spite of these notable limitations, hedge funds that feature short positions continue to proliferate in the hedge fund space - largely due to significant turnover among short-only funds that have folded. There will continue to be an active market in shorting, particularly among funds that can spot asymmetries in market pricing.
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