It's not easy to short a stock these days. While the average hedge fund is up 8% so far this year, portfolios that bet on falling prices are down 5.5%, according to Hedge Fund Research Inc.
What's to blame? Certainly, the strong markets haven't helped. But the strategy is suffering more from the sheer number of short-sellers playing the game--a dynamic that is crowding certain stocks and pushing up costs. The private equity boom, which keeps a floor under the price of beleaguered stocks, only complicates matters (see BusinessWeek.com, 7/11/07, "Kill the Private-Equity Tax Break"). "We're hearing it's harder and harder to make money on the short side," says Robert Discolo, head of hedge fund strategies at AIG Global Investment Group (AIG).
That's not stopping investors from trying their luck at shorting stocks. Once the domain of a few specialists, the strategy is now routine for thousands of individual traders, hedge funds, and even mutual funds. In June, short interest on the NYSE Euronext hit an all-time high of 3.3%, or 12.4 billion shares, double that of 2000.
Much of the recent growth is coming from new products like the so-called 130-30 fund, a cheaper alternative to traditional hedge funds being developed by banks, mutual fund companies, and other asset managers. Such portfolios sell short 30% of their assets, using the proceeds to extend the long position to 130% of assets. A few years ago, there were just a handful of these funds. Now, there are more than 100.
The increased competition, in turn, is driving up costs. That's because the more popular a stock is among short-sellers, the more expensive it is to borrow. In a typical short transaction, hedge funds or other investors put up cash as collateral to borrow the stock they want to short from a bank or broker. In return, those securities dealers pay them interest on the cash, generally in line with short-term rates, roughly 5.25% today. That helps generate income for the funds.
But if there are too many shorts swarming a company, investors must pay to borrow the stock. Especially hot names like Internet retailer Overstock.com (OSTK), with a 31% short interest, and chipmaker National Semiconductor Corp. (NSM), at 16%, can be particularly costly. Hard-to-borrow stocks can cost 2% to 40% a year, meaning the price has to fall by at least that amount before the short-sellers can make any money. "As more 130-30 and hedge funds raise money, I think demand for borrowed stock could easily outstrip supply, and the costs will go up," says Josh Galper, managing principal of researcher and consultant Vodia Group.
The leveraged buyout boom is making life even more difficult for shorts. With LBO deals reaching a record $737 billion in 2006, underperforming companies are hot properties. Those stocks often sell at a premium, since investors are banking on a buyout boosting the price.
Consider the roller-coaster ride of shorts in Jones Apparel Group Inc. (JNY), which owns Jones New York, Nine West, Anne Klein, and other brands. After the company cut profit estimates in late 2006, shorts circled the stock, then trading in the high 20s; short interest stood around 7%. But takeover rumors pushed shares up to 35 by April, 2007. It's now around 29, after management announced it had received a $900 million offer from a Japanese apparel company for its Barneys New York retailing unit.
Steven D. Persky, founder and CEO of Dalton Investments, says the "private-equity effect" has ruined several of his recent shorts like Tekni-Plex Inc., which produces packaging for health-care products. He shorted the company's bonds, figuring Tekni would stop making payments. But private equity firm MST Partners came to the rescue and ponied up the cash to tide Tekni over.
Persky has since closed a $300 million fund that held most of his shorts and is shying away from the strategy in two other portfolios. He's not alone. One longtime short-seller, the $175 million Keel Capital Management, has exited the game, citing the lack of opportunities. Some have shifted their strategy, avoiding shorting single stocks and betting against indices instead. "The game is much more competitive," says Persky. "I doubt many firms have made a lot of money on the short side."
Join a debate about the tax breaks on private equity gains.
By Steve Rosenbush