Hedge fund market gets crowded- Too many short sellers: Ability to add value through shorting

Date: Friday, October 1, 2004

Keith Kalawsky: Financial Post-- Like a two-pack-a-day smoker going cold turkey, a big-time U.S. hedge fund is giving up on short selling. As strange as that sounds, Steve Mandel at Lone Pine Capital LLC in Greenwich, Conn. is throwing his hands up on short selling because of a lack of decent short ideas, coupled with the massive flow of assets into hedge funds. With more and more money chasing a finite group of stocks, "the ability to add value through shorting in the years ahead will be more limited than it has been," Mr. Mandel told the Web site, Seeking Alpha. Since he can't make decent returns by shorting, Mr. Mandel is starting a new fund that will only make long-term investments. In his view, "a long-only fund can provide competitive net returns with a comparable long-short fund over the intermediate term." Sound familiar? Yes, Mr. Mandel is starting a mutual fund. The long stock picks of Lone Pine, which manages several billion dollars and was picked as hedge fund leader of the year by Alternative Investment News, have apparently beaten the S&P 500 over the last few years, producing a 48% return compared to 20% for the S&P, he told the Web site. If Mr. Mandel is right about the futility of shorting, then what's the point of investing in a hedge fund (at least a long/short hedge fund)? As the popularity of hedge funds continues to rise, mutual fund companies are fretting about losing assets to so-called alternative investment managers, or hedge funds. In turn, some retail mutual funds have sought regulatory approval to short stocks. Meanwhile, big U.S. investment dealers including J.P. Morgan Chase & Co. and Lehman Brothers Holding Inc. are buying hedge funds to get a piece of the action. Earlier this week, J.P. Morgan announced the acquisition of Highbridge Capital Management in New York, which manages about US$7-billion. And Lehman is reportedly pursuing GLG Partners LP, a hedge fund in London, England that handles US$12.5-billion. At the same time, however, hedge fund returns are falling. As Bloomberg News pointed out, hedge funds reported average returns of 2.75% in the first eight months of 2004, according to the CSFB/Tremont Hedge Fund Index. Last year, hedge funds produced a 15% return on average. But excluding that stellar year, funds have not posted returns above 5% since 1999. Take a step back for a moment. If hedge fund returns are falling at the same time that hedge funds are selling out, then this could mean that hedge funds believe their best days are behind them. "It's potentially a sign of the peak of the market," Eileen Fahey, who analyzes securities firms and banks for Fitch Ratings in Chicago, told Bloomberg. In Canada, the hedge fund sector is still nascent, with only a handful of companies breaking the $100-million in assets barrier. So there is still room for growth, but for how long? Hedge fund managers here insist that short selling is much less popular in Canada than the U.S., at least so far, which leaves Canadian managers plenty of good opportunities to make money. "The overcrowding in U.S. shorts really doesn't exist to any large extent in Canada," says Colin Stewart of JCClark, an investment management firm in Toronto and one of Canada's largest hedge fund companies. "That's why we think the opportunity on the short side in the Canadian market is so compelling." In Canada, the hedge fund industry is roughly 0.5% the size of the entire equity market, while in the U.S., that figure is about 5%. Put another way, the U.S. industry is 10 times larger than Canada's on a relative basis. The Canadian industry is definitely growing rapidly, though it is far from being a craze. Assets under management have increased from just $2.6-billion and 46 funds in 1999 to $11.9-billion among 181 funds in 2003, according to Investor Economics. Compare that to the $470-billion invested in mutual funds, according to the Investment Funds Institute of Canada. In the U.S., the hedge fund industry has swelled to US$865-billion in assets, from US$39-billion in 1990. More importantly, the average short position in Canada stands at about 1.5% of the shares outstanding on the S&P/TSX composite index compared to about 3% on the S&P 500. In addition to having more hedge fund assets, the U.S. is home to gigantic proprietary operations at investment dealers like Morgan Stanley and Goldman Sachs, which are also shorting stocks. Shorting is so popular in the U.S., there are now research firms dedicated solely to pushing short-selling ideas. These kinds of reports circulate widely and encourage even more investors to short sell. So there is plenty of evidence that shows shorting may be getting more difficult in the U.S. That means we may see more money managers like Mr. Mandel decide that going long is the way to go. But it's hard to see how it will be any easier for Mr. Mandel and others to return to long-only investing to beat the major equity indices. Good ideas for longer-term investments are even tougher to find than good shorts, with hedge funds, mutual funds and other investors all searching for opportunities. As Mr. Stewart of JCClark says, "The problem with crowding doesn't only exist on the short side." © National Post 2004