As the number of hedge funds continues to expand, the opportunities to short stocks is shrinking, MarketWatch reports. According to some estimates, the percentage of shares sold short on the New York Stock Exchange has doubled since 2000 to about $500 billion a year.
Thus, rather than short a stock because of a belief that its fundamentals are deteriorating, hedge fund managers are taking riskier bets that the company might simply miss profit forecasts or have a couple of bad quarters.
“These are the types of positions that can kill hedge fund managers on the short side,” said Jeff Bernstein, co-founder of Keel Capital Management. “There’s no smoking gun, but they tend to pile into these types of positions.”
Mark Sellers discovered that when he founded his hedge fund, Sellers Capital, in 2003, his clients were skittish about his plans to short stocks. So, he invests in undervalued companies instead. “I’ve found that I’m not very good at shorting,” he said. “If I was good at it, I would do it. But I tend to find out about them after everyone else, and by then the trade is crowded and it’s hard to borrow the stock. Shorting is such a tough game to play. There are so few ideas out there.”
The spread between the most highly valued stocks and the most undervalued is also the thinnest in 55 years, according to Praesidium Investment Management.
“Today, the amount of money dedicated to [short] strategies and the percentage of shares sold short are at the highest levels ever recorded, yet valuation spreads and the opportunity set are the smallest in over five decades,” according to Praesidium.
Yet another factor making shorting so challenging is the current leveraged buyout craze, making companies that were good short targets now good LBO targets. “Shorting single stocks has really hurt a lot of people because they were shorting things that ended up being acquired,” said Cynthia Nicoll, chief investment officer of Tremont Capital Management. So now, in addition to assessing a stock for its value as a short position, managers have to also “evaluate businesses in terms of their ability to be bought out in an LBO.”