Some hedge funds frozen by SECs ban on short selling

Date: Thursday, September 25, 2008
Author: Dow Jones Newswire

The short-selling ban is taking the "hedge" out of hedge funds.

The Securities and Exchange Commission has banned short sales of roughly 950 financial-related stocks until Oct. 2, a list that ranges from Goldman Sachs Group Inc. to International Business Machines Corp.

With their hands tied on those stocks and the algorithms that do much of their trading running into technical hitches, many quantitative and other "market neutral" hedge funds are drastically reducing trading activity, according to Wall Street sources.

Once major buyers and sellers on the stock market, these funds may have to reinvent their models in the event of an extension of the rule beyond Oct. 2.

"There are very, very few short-only funds on Wall Street, so the ban mainly removed long/short funds from the market," said Dan Mathisson, head of the algorithmic trading unit at Credit Suisse Group. "If they can't put on their short positions, they can't put on their long positions, either. It's just breaking down a lot of their models, and the end result is they're walking away. A lot of funds are reducing the size of their books."

Market neutral funds offset the risk of random market swings they take when buying stocks by short-selling, or selling borrowed stock, on an equivalent dollar amount of other shares. That way, as long as they choose their stocks well, they will make money whether the market goes up or down.

Many of these funds are "quantitative," and use mathematical models to identify relative strength and weakness—read financial stocks—in the market.

Often, automated "algorithmic" trading programs keep their portfolios balanced between the long and the short side. Removing a large chunk of the "shortable" universe upsets that cosmic balance.

A person at one of the largest quantitative hedge funds said the short rule has caused the fund to trade less. Other sources said that, at smaller "quant" shops, trading has slowed considerably.

Lorenzo Di Mattia, manager of non-quantitative hedge fund Sibilla Global Fund, said "people are holding an enormous amount of cash" partly because of the short rule, and partly because, after the fall of Lehman Brothers, they want to be nimble and ready to move cash from brokers at short notice.

Most sources said larger hedge funds with big quant operations, such as AQR Capital Management and Renaissance Technologies Corp., are affected much less by the rule than smaller shops.

One reason the smaller funds may be disadvantaged: loopholes are expensive. In one way around the rule, a fund would sell the S&P 500 index short, then buy all but the financial stocks they wanted to short in that index. Their net exposure to the financial stocks chosen would then be short.

"But a large amount of capital is tied up, and the financing costs are high," said Mathisson, of Credit Suisse. "As a result, most long/short fund managers are shrugging their shoulders, and saying 'yes, there are some ways around the rule but they're too expensive to be worthwhile'."

Making that tactic even tougher, representatives of trading desks at two major Wall Street firms said they are preventing short-selling of some instruments linked to the S&P 500.

The inability to sell borrowed shares also limits the cash available for the funds to buy stocks, said Cleve Rueckert, an analyst with Birinyi Associates, a research and hedge-fund firm. The short sales generate cash that can immediately be put to use, Rueckert said, effectively giving the funds a little extra leverage.

Volumes Monday and Tuesday ran at about five billion shares on the New York Stock Exchange Composite. That's historically high, but half the record volume of last Thursday. Volume was running at the reduced rate again Wednesday.

On the technology end, sources said the designers of trading algorithms—computer programs that automatically adjust and execute orders at lightning speed to fit set parameters—scrambled to make sure they complied with the order.

"Our clients immediately got off conference calls with the SEC thinking they had to institute new things in the automated systems so that they can comply with the new guidelines," said Mark Palmer, president and chief operating officer of StreamBase Systems, which makes algorithmic trading platforms used by hedge funds and brokers.

Palmer said the moves initially halted many algorithmic systems that have built-in shorting strategies. As of Tuesday, many of those still weren't back to normal, he added.

Some automated trading systems are more flexible than others, Palmer said, and some could even be rendered useless.

Yet, "you cannot withdraw from algos. If you do, you're going to put yourself out of business," said Palmer. "You can't compete in the trading space without millisecond response in the face of high volumes."

—Write to Rob Curran at robert.curran@dowjones.com; Geoffrey Rogow at geoffrey.rogow@dowjones.com; and Joseph Checkler at Joseph.checkler@dowjones.com