Lifting the lid: Hedge funds pinching short-sellers

Date: Thursday, June 24, 2004

(Reuters) - The bears of Wall Street who specialize in short-selling are growling at hedge fund managers, warning the weak-of-heart to keep away from their game. Indeed, some dedicated contrarians who profit from falling stocks say the rapid rise of hedge funds has spawned a rush of amateurs into the high-risk, sometimes big-reward, business of short-selling. The result: short-sellers' costs are rising with the increased demand, and they're getting squeezed more by newcomers who buy shares in a panic to cover short positions. Short-sellers know their betting on a stock tumble makes them exposed to potentially unlimited losses if the stock soars. That prospect has some newcomers shaky, apparently. "The amateurs have weak stomachs," said investment consultant Harry Strunk, whose firm in Palm Beach, Florida, has tracked short-sellers for two decades. "Rather than maintain their short position like professionals would, they're panicking, which creates buying pressure." The average short portfolio got hammered last year and in the first five months of 2004, stocks with the highest degree of short interest have outperformed stocks with the lowest, according to Zacks Investment Research, a Chicago-based research firm. That reverses a three-year trend and means the most heavily shorted stocks are on their way to thumbing their noses at bearish investors this year. Rising costs are also a concern for contrarians. Veteran short-seller James Chanos said lenders are catching on to the spike in demand and charging more, meaning "they're making more money, and my clients are making less just in the transaction to borrow the shares." "I just think there are a lot of people new to the game who don't understand the various aspects of short-selling," said Chanos, who is president of Kynikos Associates Ltd., a New York-based hedge fund with roughly $2 billion in assets. One grizzled short-seller said some hedge-fund meddlers were "kids" in the short-selling pool. "They hear a company name that's popular among the shorts, and with no investigation, they take a short position," he said, requesting anonymity . Long-term investors and corporate executives alike are unlikely to shed a tear for short-sellers complaining of a crowded playing field. One veteran bear scoffed at the hedge fund factor, calling the claim "idiotic," and adding that unwarranted stock upticks are part of the game. The short game may in fact become more appealing to newcomers. The U.S. Securities and Exchange Commission on Wednesday approved a pilot program to lift short-selling limits on about 1,000 large, liquid stocks. "Inexperience adds volatility to the short strategy. These investors short stocks for the wrong reason and it becomes a nightmare," said Matthew Feshbach, chairman of MLF Investments and a former short-seller. TRIMMING THE HEDGES Short-sellers make their money by borrowing shares then selling them, hoping the stock price will fall so they can buy shares at the lower price for return to the lender and pocket the difference. A plummeting stock can mean massive profits for bears. In 2003, the short portfolios lost 28 percent on average and they are down 1.2 percent so far this year, with a 1.6 percent drop in May, according to Strunk, the investment consultant. The tumble can be attributed to the bull market, where stocks rose, squeezing the bears. But Strunk points out that during the 1985 to 1990 bull market, the average short portfolio was up more than 30 percent, according to his index. Short profits slipped during the technology boom of the late 1990s, around the time hedge funds began to proliferate. Today there are 6,700 hedge funds, up from 5,300 in 1999 and 68 in 1984, according to Tremont TASS Research, a Rye, New York-based asset management and research firm. With the influx came the growth of hedge funds taking both long and short positions. Veteran short-seller Manuel Asensio said the government needs to place stricter regulations on the short market. "We wouldn't have a problem with amateurs if government regulators were available to introduce more restrictions and educate people on how to short sell," Asensio said.