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Lessons learned from a year of burnt fingers

A dramatic 2021 has given short-sellers plenty of food for thought, and evidence suggests some are now taking a more cautious approach to betting against companies
Lessons learned from a year of burnt fingers

Short-sellers often say they thrive on market volatility, but few would have found the events of early 2021 to their liking. The wave of retail money that gave birth to the notion of 'meme stocks' has yet to go away, and there are signs that professional investors – in both the US and the UK – have changed tack in response.

Short-selling is a controversial topic, and one that has been discussed in these pages several times before (‘Lessons from history: Short-selling bans are ill-advised’, IC 26 February 2021). It suffices to say that the collapse of companies such as Carillion or NMC Health shows such investors can play an important role in holding businesses to account and aiding price discovery.

But as this year has proved like none before it, they don’t always come out on top. Last January saw Reddit-inspired traders go up against hedge funds, and thus far it’s the retail crowd who have won out. A reckoning has still to emerge for either of the principal meme stock poster children: at the time of writing, shares in both GameStop (US:GME) and AMC (US:AMC) remain several hundred per cent higher in the year to date.

This share price resilience, also evident in companies such as Tesla (US:TSLA), has caused no small amount of angst among the hedge fund community. Some have sustained heavy losses; others have either downed tools or at the very least paused for thought. Michael Burry, famed for his bet against the US housing market as dramatised in the film The Big Short, is among the high-profile names to have called time on bets against Tesla this year. Crispin Odey bemoaned the “endlessly costly” habit of shorting “very expensive shares” in an investor letter seen by the Financial Times this month.

The Reddit effect has had an observable impact on many of these share prices, but there are wider risks for short-sellers at the moment. Attempting to bet against companies at a time when a wave of cheap money continues to push stock markets higher is a particularly risky business.

Whatever the reason, the scaling back of US short-selling activity can be empirically verified, and is not confined to tech or meme stocks.

Goldman Sachs’ hedge fund monitor reported in November that short interest for the typical S&P 500 company remains “close to the lowest level on record”, having fallen from 2.2 per cent at the beginning of 2020 to 1.5 per cent at the start of this year. Short positions remain below their 25-year average in every sector.

For all their complaints, many short sellers have weathered this storm pretty well. Figures from Société Générale and data provider Eurekahedge shows long/short strategies globally have performed better than most other types of hedge fund in 2021.

But that outcome is not inconsistent with a scaling back of short exposures. In a rising market, many funds may have become more akin to long-only equity funds. That would have allowed them to make money more easily than rivals who also make calls on fixed income or currency market positions.

 

Median US stock short interest as share of market cap
SectorCurrent (%)25-year average (%)
Commercial Services2.22.3
Real Estate2.23.3
Energy2.12.7
Consumer Disc2.63.5
Consumer Staples1.41.8
Materials1.62.5
Industrials1.52.2
Financials1.42
Healthcare1.32
Information Technology1.72.8
Utilities1.22
S&P 5001.62.3
Based on hedge fund filings. Does not include synthetic short interest
Source: Goldman Sachs Global Investment Research

 

The UK view

For private investors, the question is whether domestic short-sellers have mimicked their US counterparts. The UK, after all, is home to plenty of investment managers who like to pit themselves against regular shareholders. Data from the European Securities and Markets Authority, analysing more than 200,000 short positions across the continent between 2013 and 2016, found 30 per cent of sellers were domiciled in the UK, compared with 40 per cent in the US and 15 per cent in the EU.

And there is evidence short squeezes across the Atlantic did have some knock-on impact on UK positions this January. We reported earlier this year (‘If I were a crook…’, IC 5 February 21) that the end of that month saw a “significant reduction in short interest” in some of the most bet-against shares in the UK market.

In some cases, these moves made intuitive sense. The drop in Cineworld (CINE) short interest, which fell from 9 per cent to 5.7 per cent in the space of a week, was understandable given the way that retail investors had suddenly started buying shares of US rival AMC.

Reasons for the fall in Pearson (PSON) short positions, which dropped from 8.7 to 1.9 per cent over the same period, were less clear. Pearson shares rallied 13 per cent on 27 January 2021: whether that was down to retail trading activity, or simply short-sellers getting out ahead of this potential activity, is difficult to tease out.

But while Cineworld short interest gradually rebounded as the year progressed, Pearson shorters have stayed away: Financial Conduct Authority (FCA) data shows at least four investment managers that reduced their short interest below the 0.5 per cent public reporting threshold in late January and have yet to return. That’s despite Pearson’s share price treading water for most of the year, prior to falling 12 per cent on an October trading update.

Overall short-selling activity has also dropped. As of 27 January last year, the 30 biggest shorts in the UK market had an average short-seller interest of 4.6 per cent. As of 15 December, this average had fallen to 3.5 per cent, according to FCA figures.

This change is not conclusive evidence in itself: it could be that the market conditions at the turn of last year, when many investors were turning their attention to the possibilities of economies reopening, presented more fertile ground for shorting than today. A rising oil price means energy companies are less obvious targets than they were in 2020. And there may now simply be less consensus on which stocks to short.

 

The funds world

The open-ended fund universe may provide further clues. Despite the rise in options trading seen this year, and the handful of short or ‘inverse’ exchange-traded funds (ETFs) available, selling companies short remains off limits for most sensible retail investors. Most investment platforms, however, do provide access to a handful of Ucits long/short funds run by mainstream asset managers. And these professional investors have not displayed the same aversion to shorting as can be seen in headline figures.

Investors’ Chronicle analysis of 10 of the most popular of these strategies show short exposure has crept higher in 2021, rather than being scaled back. Gross short positions accounted for 44 per cent of the typical portfolio at the start of the year, compared with 47.3 per cent by the start of October.

Only the two US-centric long/short funds in our sample have materially cut back on short positions this year. And as it happens, not all UK-based funds investing in the US managed to avoid meme stock pitfalls in 2021.

The IC understands one wealth manager sold their position in the Sanlam US Absolute Return fund earlier this year because they disagreed with the wisdom of shorting meme stocks in such febrile markets. The Sanlam vehicle sustained double-digit losses in the final week of May and was subsequently closed as part of what the company described as an "ongoing review process".

Blow-ups are not uncommon in the sector: the asymmetric risks of shorting stocks (the upside is limited; the downside is not) has spelled the downfall of more than one manager in recent years. But there is no evidence that 2021 has done more damage than usual. On the whole, long/short managers able to be accessed by private investors have generally posted unremarkable yet respectable performance this year. Although most have underperformed conventional benchmarks, that is in keeping with the typical fund’s goal of providing a less volatile exposure to stock markets. Whether these low-volatility approaches can be maintained over the long term is a different question.

Anecdotally, the mood on the ground is mixed. The managers of the Man GLG Absolute Value fund (GB00BF1X8084), discussing their own short-selling difficulties in the first half of 2021, put these down to stock-specific issues rather than a structural shift. They told their investors that “in the UK we have been spared much of the volatility seen in the US, and it is hard to argue that short squeezes and retail-driven raids on short-sellers has made this period harder to short in aggregate”.

But there are signs that some managers have adapted their approaches in response to the events of 2021. Many US long/short managers have resorted to shorting benchmarks rather than individual stocks this year, and certain managers have followed suit in the UK.

The Majedie Tortoise fund – not usually available to retail investors – cut back on its handful of single-stock US and UK shorts in the first half of 2021 in favour of short futures positions in the S&P 500 and Nasdaq indices, according to company filings. The BlackRock UK Absolute Alpha fund (GB00B06L9G55) has also started running bigger index future short positions – although this, according to its managers, is in response to a “higher level of merger and acquisition risk”.

As this implies, heightened dealmaking activity, fuelled in particular by a wave of private equity money, has been another issue for domestic short-sellers to deal with of late. The sizeable short position in Morrisons prior to this year’s bidding war and its eventual acquisition by Clayton, Dubilier & Rice was a good illustration of that risk.

Yet as is so often the case, fund managers strike a bullish tone when looking to the future; they point to growing levels of stock dispersion in the UK and elsewhere. The prospect of tighter monetary policy might also bolster their arguments. Investors’ anticipation of this shift has helped some of the more popular short positions regain some ground in the closing weeks of the year.

The realisation that the Federal Reserve could tighten policy more than expected in 2022 hurt many of the most shorted US stocks in December. The Ark Innovation ETF – a popular short among US investors betting against richly valued technology names – has fallen more than 20 per cent since its near-term peak on 11 November.

All the same, base rates of interest are only going to rise so far; the era of easy money isn’t over just yet. The frothier parts of the US market could be at risk, but the UK, which has underperformed global peers over the past five years, is perhaps less likely to produce easy pickings for shorters.

The impact of Covid-19 also continues to complicate the picture. The past two years have also seen companies swing in and out of favour with each twist and turn of the pandemic, and this volatility applies as much to balance sheets as it does to share prices. In many sectors, company earnings, cash flows and exceptional items have fluctuated much more than usual, making short-term comparisons tougher than they once were.

As a result, some short-sellers are factoring in a broader range of metrics and taking a longer-term view when deciding on their positions. Needless to say, these analyses are worth long-only investors’ consideration, too. Seb Jory of UK equity fund house Tellworth, for instance, has expanded his basket of short ideas this summer to include new red flags such as auditor cost as a proportion of Ebit – seen as an indicator of the complexity of a company’s accounts, and hence its business model.

Direct investors may not always agree with a short-seller’s methodologies, let alone their targets, but their analyses will continue to provide a useful sense check for individual portfolios. That is a conclusion that applies regardless of whether or not next year proves a rockier one for stock markets – and irrespective of how successful individual short-sellers turn out to be.