Have hedge fund managers just lost it? More and more leading managers are returning assets to their clients. The reason is the melt-up of the market, making it ever harder for short-sellers to identify profitable trades.
For example, this summer John Paulson (photo), who earned $15 billion from the collapse of the US housing market in 2008, known as “The Greatest Trade Ever”, announced his departure from the hedge fund industry. Others, such as George Soros, Stanley Druckenmiller and David Tepper, preceded him.
Many of the world’s best-known hedge fund managers have become world-famous with one “bet”, like George Soros who speculated against the British pound in the 1980s and made over a billion dollars for his clients.
Meanwhile, the industry has lost its halo of ‘magic hands’: the 2% - 20% earnings model is being eroded; according to the research firm HFR, fees have even fallen to 1.14%, while institutional investors have little patience with hedge fund managers who do not perform well enough.
Drop the shorts
Scientific research also shows that going short is far less profitable than going long, as Robeco’s quants (David Blitz, Pim van Vliet and Guido Baltussen) discovered when they examined whether they could build a long-short strategy based on factor premiums. Their paper When Equity Factors Drop Their Shorts received a lot of international attention, because it was so damning for hedge fund managers.
Source: Bloomberg/Robeco
The research shows that factor investors buy stocks that score high on attributes with demonstrably better risk-return ratios, such as momentum, value and low volatility. At the same time, however, shorting the poorly scoring stocks of a certain sector or the market does not produce additional returns.
The quants concluded from their research that most value is added by ‘long’ trades. These selected long stocks offer more diversification, while the return on short positions was also lower. In other words, factor premiums can be collected most efficiently by dropping the shorts.
Even though the conclusions do not even take into account the relatively high costs of shorting, they remain valid for both large and small caps, over time, in different countries, and they cannot be explained by tail risks, according to David Blitz in a commentary.
‘The most unprofitable short ever’
In mid-August, ‘the haters’, as top man Eon Musk calls them, had over $20 billion in short positions in Tesla outstanding. Without much success initially: the price/earnings ratio of the manufacturer of electric cars had exceed 1,000, turning Tesla into the longest unprofitable short ever, according to market commentators. But this week, prices finally started falling. On Tuesday, for example, technology stocks lost more than 3% again, with Tesla down 21%. For now though, the auto maker’s P/E ratio is still at an unprecedented 876. For the time being, the market assumes that this is nothing more than a healthy interim correction in a market driven by bulls.
Robeco’s Blitz does not want to go into individual stocks, but acknowledges in a general sense that going short in a specific company is very defensible - for example, the investors who speculated against fraudulent Wirecard have made good profits from it; but these are expections. The recent price drop of Tesla, for example, is just a drop in the ocean of the market melt-up.
‘Play more factors’
If you want to play long-short and keep market sensitivity at zero, then going short in high risk stocks is particularly difficult to manage. Certainly in a melt-up. ‘If you’re short, that can have a huge impact on you as losses are unlimited in theory’, says Blitz.
A melt-up, which now appears to be the ase on Wall Street after a 50% rise in prices, offers great returns to investors but the risk increases accordingly. For example, the P/E ratio of the US MSCI Growth Index has exceeded 45 - a level we have not seen since the 1990s, Blitz warns.
He therefore advises to play additional factors, such as momentum. ‘You can profit from the quality/growth rally now, but watch out. For example, quality stocks are very popular at the moment, but their weakness is that you have to ask yourself at what price you want that underlying profitability. If the market starts doubting whether current valuations are justified, you have to move quickly into other factor premiums. Value is certainly one of them, although it has been hard to make money from it in the past two years.’