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The “Short Sale,” the secret sauce behind market neutral products …


Date: Friday, May 25, 2012
Author: Edward Strafaci, Reuters

The “Short Sale,” the secret sauce behind market neutral products … What Baseball teaches us about professional conjecture

Ask any hedge fund expert or Wall Street professional and they will acknowledge that the short sale is the magic behind hedged strategies. Think of the short sale of equity in the context of Superman’s Bizzaro World where everything is opposite. For instance, purchasing equity requires a capital outlay, a short sale creates capital. A long stock position entitles the owner to capital appreciation and dividends. Short sellers make money when a stock depreciates, and since they must use borrowed shares, they owe the lender dividends paid while the stock is in their possession. In the final analysis, a long equity holder has unlimited profit potential while the short seller can lose infinitely and only benefit to the extent that a stock reaches zero. In all respects, it is the inverse of a purchase, yet, when combined with a long position, it establishes the very essence of why “hedge funds” were conceived.

To fully understand the short sale, let us go through a fictional transaction using our ABC stock previously mentioned in TTA. If you recall, ABC common paid a 2% dividend (40 cents) and traded at $20 per share. If one wished to short 100 shares of ABC, they would first have to contact their clearing broker and arrange to borrow the shares of ABC. Assuming the stock was available at the clearing broker, the short seller would sell 100 shares at the market for a $2,000 credit (100 shares x $20). The short seller would then deliver to the buyer the borrowed shares. In turn, short seller would give its clearing broker the $2,000 as collateral for the borrowed shares.

The clearing broker would invest that capital in an ultra-short term, presumably safe investment, such as LIBOR or Fed overnight funds. When the transaction is unwound (the purchase by the short seller of 100 shares of ABC stock, hopefully for less than the $20 per share price at which he sold it) the shares would be returned to the lender and the collateral would be used to pay for the purchase. The broker and the short seller would split the proceeds of the interest earned by the broker during the period the short sale remained outstanding. The short seller’s end of those proceeds is called a rebate and is usually expressed as a percentage of LIBOR or Fed Funds. That is the mystery, from an accounting perspective, of a short equity sale.

As far as the clearing broker is concerned, there is a very good deal in this transaction. A broker sources borrowed stock in one of two ways. One method is to go to other brokers, or long equity holders, (mutual funds, foundations, etc.) and borrow their available shares. In this case, both broker and lender split the proceeds. The other more profitable approach is to use shares that are in the broker’s domicile, thereby earning their full share of interest accrued. However, the key is just how the broker has those shares in the first place. Usually it is because their clients own these shares in margined accounts. When a client margins a stock, they sign a hypothecation agreement. Hypothecation, for our purposes, is fancy French for a contract that allows the broker to use those shares for short, fully collateralized, “loans.” Since the loans are fully collateralized by the short seller’s funds, there is virtually no risk to the broker except in extreme circumstances. Thus, the broker lends to a client at broker loan and can collect interest from a short seller (arbitrageur) as long as the loan is outstanding.

This arrangement is beneficial to all parties concerned. The lender gets a credit for stock that would otherwise be held dormant. The borrower gains access to the stock and the broker earns a deserved fee for acting as an agent. The longer the loan is outstanding, the better it is for all. This is why the arbitrageur (convertible, option, merger or otherwise), who may retain a short hedge for months or years, is a valued client. In the case of the convertible hedge fund, the short protects the long convertible position while generating positive cash flow, a subject we will cover soon. This is a position the convertible arbitrageur may hold for a long period, continually re-hedging his position while earning interest. Suffice to say, it works for all sides of the transaction.

In effect, the rebate earned by the hedge fund helps to cover the long financing cost of the convertible security. As we will thoroughly review in future sections, the short rebate can in fact, cover most of the long debit cost. Given the yield spread between the interest earned on the convert and the dividend paid by the arbitrageur to the stock lender, the set-up becomes very attractive. To summarize, the rebate earned by the short seller makes up for most of the long financing in most market neutral strategies—that is why it is the “secret sauce” of market neutral products.

A few final caveats concerning the short:

- The borrowed stock must be freely available. If not, the consequences range from a smaller rebate to an outright demand for the stock if it becomes scarce. This situation is known as a “short squeeze.” The latter can be disastrous for the arbitrage set-up.
- The rebate percentage is, like all things financial, negotiable. A bigger fund can demand better rates creating an “economy of scale.” We will also demonstrate in the future how the rebate rate affects option pricing.
- Since the lender pays the borrower a dividend, unexpected dividend increases can be harmful to the arbitrageurs’ spread. Therefore, dividend projections loom large when viewing a market neutral set-up.

We are now ready to look at hedging. Our next TTA will begin to explain the process of hedging a long convertible security. We will explain a convertibles delta, and how volatility impacts a hedge. More than any other factor, here is where the convertible arbitrage position becomes an art form. This is where arbitrageurs earns their keep.

Baseball … as we approach Memorial Day

Baseball aficionados view Memorial Day as a time to adequately assess a baseball season. At this point, there have been approximately 40 games played, or 25% of the season. It is enough of a sample to be meaningful. With that said, here are a few of the surprises:

- The prognosticators favored the Detroit Tigers and Miami Marlins to dominate; both teams have disappointed so far.
- The lowly Baltimore Orioles and New York Mets (as a disclaimer I am a die-hard, patient Mets fan) have played competitive baseball, far above their expectations.
- Highly paid free agent Albert Pujols (in fairness arguably the best hitter of his generation) has failed to produce in his legendary fashion.
- The once-written-off-as-over-the-hill Derek Jeter is playing as well as at any time during his storied career.

What this tells us is that predictions are many times only worth the paper they are written on. Witness the disappointing debut of Facebook’s IPO. There are those that spoke of Facebook’s success in the market as a fate accompli. I guess they forgot about AOL or Web MD. For Facebook CEO Mark Zuckerberg and company, it is clearly a win. Yet, Facebook’s eventual triumph as an equity is yet to be determined.

The Tigers, Pujols or Zuckerberg may eventually knock it out of the park. Nonetheless, it has not yet worked out as neatly as the mavens prophesized. I like to save old newspaper clippings of forecasts and revisit them later. It gives me a sense of perspective. Reconsidering stories such as “the can’t miss” draft pick who floundered, the highly criticized movie that became a cult classic, the business genius whose strategy ultimately proved fruitless or the glamorous movie star we hardly remember … are life lessons worth learning.

Then there are the Jeters, the Eli and Peyton Mannings or Kobe Bryants. They prove to us that hard work, determination and humility ultimately win consistently in the end. They serve as reminders that the games must eventually be played in order to resolve the contest. You cannot determine a victor on paper. Investors will be well advised to remember this when reaching for the next hot fad while passing up a genuine value play.

Until the next time …The Thoughtful Arbitrageur

Edward Strafaci is not an investment adviser. Nothing he writes should be construed as investment advice or an endorsement of any particular security. From time to time, a family trust with which he is associated may have positions in the securities he writes about. When it does, he will tell you. What he writes is meant to inform and in some cases to entertain and amuse. HedgeWorld’s Alternative Reality is not an investment advisory site. As a general rule you should not take investment advice from blogs, anyway. Consult a financial professional for investment advice, not a blog.