to be bottom line-oriented; they want to know
how their investment performed and tend not to
be overly concerned with the details. Yet, how
an investment achieves its return is one of the
most important questions an investor can ask.
The focus of this article is on the following
question: can a long/short fund actually generate
short side alpha?
In its purest form, alpha is merely a piece of
statistical output that is generated from a regression
analysis between the returns of some investment
and an underlying benchmark. Assuming the regression
is statistically meaningful, alpha measures the
portion of the investment's returns arising from
specific (non-market or non-benchmark) risk. In
other words, alpha is a measure of a fund manager's
skill level in adding some sort of value beyond
a simple benchmark investment. For example, an
alpha of 1.1 indicates that an asset, based on
historical data, is projected to rise in price
by 10% in a year when the return on the benchmark
and the beta of the asset are both 0.
An interesting side note is that many in the
alternative investment community incorporate various
definitions of alpha to fit their distinct viewpoints
of the hedge fund landscape. Consider, for example,
the secretive world of hedge funds. In many cases,
focusing solely on a hedge fund's return series
can lead to erroneous conclusions regarding a
manager's ability to produce alpha. Simply put,
a manager has not necessarily added alpha just
because he has outperformed his peer group or
has produced positive returns.
Now that alpha has been defined, we are prepared
to tackle the main issue: can short side alpha
be generated in long/short equity strategies.
Specifically, we will examine anecdotal evidence,
the barriers to effectively sell short, whether
short side alpha can even be calculated and whether
such a calculation is relevant when applied to
varying sub-classes of long/short strategies.
Do managers actually offer any hard evidence
that they generate short side alpha?
Many managers claim the ability to add short
side alpha. On the surface, this assertion may
seem plausible. Yet most hedge fund managers offer
little evidence in this regard. Managers do not
provide investors with an audit detailing the
timing and performance of each short position.
Instead, investors receive an annual audited performance
figure. How many investors run the proper analysis
to determine if alpha was generated on the short
side? If they did, I believe the results might
surprise them. Indeed, an analyst from a well-regarded
fund of funds told me that he could count on one
hand the number of long/short managers that actually
added alpha on the short side of their strategy.
What impediments do short sellers face?
Right from the start, the odds are stacked squarely
against the short seller. What long managers take
for granted, short sellers cannot. Four of the
biggest issues facing short sellers are the ability
to borrow, execution impact, capacity limitations
and quantitative modelling.
Ability to Borrow: In order to short a
stock, short sellers must first borrow the security
via their prime broker's stock loan department.
When shorting, the seller receives short credit
rebates equal to some percentage of the fed funds
rate. However, if a stock is "hard to borrow,"
instead of receiving short credit rebates, the
short seller may actually have to pay interest
in order to borrow the security. This situation
is a minor problem in comparison to a short squeeze.
Furthermore, 100% of a company's stock is never
available for shorting. In reality, 25% is considered
to be a rather large number. On this basis, there
is much more inventory for long managers than
there is for short managers and monumentally more
liquidity in the large-cap universe than the small-cap
universe. Generally speaking, the issues surrounding
the borrowing of stocks can severely hinder a
manager's ability to short by limiting stock selection
and position sizes. This fact becomes amplified
when considering small- to mid-cap stocks, lower
priced stocks and moderate to highly illiquid
Execution: Due to the up-tick rule, entry
into a short position presents more difficulty
than entry into a long position. In addition,
orders are marked as "short sales." If a savvy
specialist, market maker or programme trader becomes
aware of a short seller's trading pattern, executions
will be severely impacted. This point is particularly
true with small- to mid-cap stocks, lower priced
stocks, and moderate to highly illiquid issues.
In general, trading slippage is much higher on
the short side than on the buy side. As an aside,
some institutional brokerage houses have designed
clever methods to avoid the up-tick rule. However,
additional maintenance costs are typically associated
with these methods.
Capacity: Not any stock can be shorted.
In fact, an analysis of the Russell 3000 suggests
that perhaps as few as 50% of the names are available
for borrowing without any obvious limitations.
In addition, as fund assets grow, managers must
pay closer and closer attention to liquidity and
market impact issues, especially on the short
side of their portfolio. When considering these
issues in conjunction with borrow-ability and
execution, it becomes obvious that asset accumulation
severely reduces the universe of shortable stocks
for any fund manager. Asset growth will eventually
force managers to invest the bulk of their short
capital in the ultra large-cap arena. As a result,
a manager's historical short performance will
have little relevance in forecasting his future
Quantitative Modelling: When a unique
factor is applied to a universe of stocks, prediction
accuracy tends to be higher on the long side than
the short side. In essence, an analysis of the
regression of that factor to historical stock
returns would illustrate that the error of the
regression on the short side is many times higher
than that on the long side. In addition, simulated
results tend to dramatically underestimate the
cost and market impact of shorting, particularly
when dealing with smaller cap stocks. Generally,
most market impact models are geared towards large-cap
investors and simply are not calibrated to capture
the execution impact of shorting mid- and small-cap
names. In addition, simulations cannot factor
in a stock's historical ability to be borrowed.
Is short side alpha measurable? Is it relevant?
We analysed three of the most common types of
long/short strategies with these questions in
Biased Long/Short Equity strategies can take
huge bets ranging from 100% long to 100% short
exposure at any given time. Moreover, leverage
ratios can change on a daily basis to maximise
the best absolute return scenario possible. Even
those managers utilising some constraints often
take huge sector bets. In any of these scenarios,
it is nearly impossible for an investor to quantify
how the returns are being generated. Did the manager
time the market correctly, own the right sectors,
short the proper individual stocks, and/or utilise
effective leverage? To efficiently address these
questions, an investor would need daily audited
return and trading summaries. Also, these issues
do not even begin to address the subject of what
benchmark to use.
Market Neutral strategies are designed to assume
zero beta exposure. From a quantitative standpoint,
the long portfolios and short portfolios are identical.
Capitalisation, sector, liquidity, and execution
biases are eliminated. The objective of these
strategies is to produce small, but stable monthly
returns over time. As long as the longs outperform
the shorts, incremental return is generated. Thus,
short side alpha generation is a non-issue in
these types of strategies.
Relative Value strategies are a "watered down"
version of the pure market neutral strategy. Many
are sector specific. For example, take the situation
of a former high profile Wall Street software
analyst who opens a relative value software hedge
fund. The manager attempts to buy a group of stocks
that are undervalued and short a group of stocks
that are overvalued. In a best-case scenario,
the manager's longs outperform his software benchmark
and the shorts under perform the benchmark. However,
what if the shorts outperform the benchmark, but
the manager's net return is still positive? In
this case, the manager produced a positive net
return, but failed to add alpha on the short side
relative to the benchmark. Should a relative value
manager be penalised for this? Furthermore, is
the utilised benchmark the proper performance
yardstick to begin with?
In a nutshell
As expressed earlier, the question of whether
alpha can be generated on the short side is not
easily answered. However, we can summarise with
- Shorting individual stocks is incrementally
more difficult than buying individual stocks
due to the up-tick rule and borrow-ability issues.
- Market impact is much greater when shorting
stocks than when buying. As a result, execution
costs can be quite high on the short side, often
much higher than simulations might suggest.
- In reality, only a portion of a company's
total capitalisation is available to short sellers.
Consequentially, this creates a capacity issue
for these sellers.
- The above reasons are amplified when attempting
to short sell in the small- and mid-cap stock
universe. Unfortunately, most inefficient security
pricing occurs in this universe.
- As assets under management climb, managers
must resort to putting their short capital to
work in the ultra large-cap universe.
Based on the evidence, short side alpha seems
to be quite elusive or, at the very least, very
difficult to measure. Perhaps institutional investors
have been focusing on the wrong issue and perhaps
they have been marketed an unattainable ideal.
Short side alpha sounds great, but is it really
attainable? Maybe the principal focus should be
on a manager's ability to produce stable and attractive
returns while being able to skilfully navigate
through periods of extreme volatility. What's
more, investors may want to home in on the liquidity,
capacity and scalability of a strategy. These
topics certainly seem more tangible than short
side alpha and, in the long run, are probably
more important to long-term capital preservation