Lending stock to yourself: nifty idea, but effectively just active long-only management?

17 June 2008

Since May 2002, a Hong Kong based enhanced index fund manager has been essentially lending stock to itself to create short positions in its long/short equity fund.  The result has been a portfolio architecture that one usually finds only at the largest, most sophisticated institutions.

The firm (”Enhanced Index Products Company” or “EIP”) was the subject earlier this week of a Reuters article that said the firm “is looking to triple its assets through a rare marriage of passive and alternative investing, creating market tracking index funds it can use to source stock for complex trades.”

Essentially, EIP uses its much larger index funds as a source for the stock borrow required by the relatively puny long/short fund - a strategy to short-selling that the firm says is “ideal solution for markets where hedge funds can’t easily or cheaply borrow stock they need for their often sophisticated trading strategies”.

Borrowing stock from your own index fund is more than just eating your own tail.  It’s a great illustration of how a long-only fund is really just a combination of two elements - an index funds and a market neutral hedge fund.  In fact, some public pension funds have used their own massive index funds to enable “synthetic shorting” by their own internal hedge fund team.  Instead of literally borrowing stock to execute a short sale, the (internal) hedge fund portfolio provides its recommended portfolio selections to the index manager, who then underweights the stocks identified as “short” by the hedge fund and uses the proceeds to overweight those stocks identified as “long” by the hedge fund. 

Anyone who has had a good look at 1X0/X0 strategies can see the potential problem though.  If the hedge fund wants to short a stock that represents a tiny fraction of the index, then the index fund might not have enough to lend.  After all, the road to 130/30 also involves underweighting and overweighting until the manager bumps up against the same limits imposed by index weights.  If more underweighting is still required, short-selling is the only solution.

Small-cap stocks with a small index-weight are usually harder to borrow than large-cap stocks with a large index weight.  So the very situations where synthetic shorting is required may also be the situations where the index fund might fail to deliver.  If so, then the strategy may not actually be ideal for stocks that are difficult to borrow “easily and cheaply” after all.  However, the strategy would still be ideal for short-selling larger cap stocks with some regulatory restriction on shorting (a common problem in the Asian markets where the fund operates).

Investors in both the index fund and hedge fund would technically be ambivalent about whether they own a long-only active fund or a “hedge-plus-index-fund”.  But what if the investors in the index fund and hedge fund were different?  How would the transfer pricing work?

EIP uses an interesting approach.  The index fund investors get no traditional borrow-fee from lending out their stock.  Instead, they receive 25% of the gross profits of the hedge fund - and none of the losses.  In other words, like the equity-tranche holders of a CDO, the hedge fund investors have to bear the brunt of any negative performance.  We can only guess that this call option on the fund is worth far more to the index fund investors than the measly or two percent per year they might have made by lending out their stock.   

According to the firm’s website, it seems the poor hedge fund investors then have to shell out 2 and 20 to the manager, leaving them with a little over half of their gross profits.  Amazingly, the fund still has an annual return since inception of 10%+ net of fees.  Nonetheless, it would seem that the hedge fund investors would almost have to be investors in the index fund too in order to make this approach worthwhile (since the fee would be a wash for investors in both funds).

While lending to one’s self may be “rare” (as Reuters reports), the effective result of doing so is far from unique.  In fact, it amounts to plain old active long-only management.  Gains on the shorts in the hedge fund would be off-set by losses on the corresponding long position in the index fund.  So like the mythical Ourboros - a serpent devouring its own tail - such a fund would always weight the same no matter how much it lends to itself.

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