In September, we suggested that the recently imposed bans on short-selling certain stocks would provide academics with a field day as they examined whether such restrictions actually had the intended effects.  We compared it to the situation immediately after 9/11 when climate researchers were afforded an opportunity to measure the effect of airplane contrails on ground surface temperatures in the United States.

Well the data is starting to roll in now.  And according to a study published by the Cass Business School in London, our contrail analogy may have been a little off the mark.  As Ian Marsh and Norman Niemer point out in “The Impact of Short Sales Restrictions“, it is virtually impossible to compare the performance of stocks during the ban with their previous performance histories.  Dramatic market volatility that was coincident with the bans meant that the usual caveat “all else being equal” simply didn’t apply.  This is like climatologists studying post-9/11 ground surface temperatures in the presence of a coincidental surge in sun-spot activity.

So instead of just comparing the statistical properties of pre-ban returns with those from the ban period, Marsh and Niemer also compare the statistical properties of the “restricted” stocks with those of the “unrestricted” stocks (summarized by us below as “A” and “B” respectively).

In other words, it’s like they’re comparing the ground temperature in the US before and after the absence of airplane contrails and the ground temperature both in the US and Canada.

Possible Findings

Everyone seems to have an opinion on the true effects of short-selling on security prices.  In part, this results from several different and apparently disparate academic studies over the years.  Marsh and Niemer point out that a 1977 study confirmed the prevailing intuition that short-selling pushed prices down.  On the other hand, they say, a 2006 study found that short-selling actually put upward pressure on prices since buyers were comfortable that all negative information was already baked into them.  Several other studies have been inconclusive with regard to prices but have found that volatility and market efficiency rise in the presence of short-selling.

Actual Findings

Unlike ground surface temperatures, the authors find that return behaviour actually changed very little in the absence of otherwise ubiquitous forces (shorting).  As they put it:

“We find no strong evidence that the imposition of restrictions on short selling in the UK or elsewhere changed the behaviour of stock returns. Stocks subject to the restrictions behave very similarly both to how they behaved before the imposition of restrictions and to how stocks not subject to the restrictions behave.”

But Wait…

While this seems to put a rest to the assumption that shorting (or the lack of it) has a dramatic effect on price behaviour, there is another important dimension to the debate - market efficiency.  Unfortunately for advocates of the shorting-as-market-efficiency-creator argument, Marsh and Niemer actually find that the removal of shorting did not increase serial autocorrelation in returns (a common measure of the randomness of the proverbial “random walk”).  In other words, markets were no less efficient without shorting.

In the end, the authors concede that any unique behaviour displayed by short-restricted stocks may have just resulted from sector-specific influences rather than the short-bans themselves.  To return to our surface temperature analogy, it’s like a comparison of US and Canadian ground surface temperatures both in the absence of airplane contrails - but with a nasty cold front moving through the US midwest at the same time.

The relatively small size of the short-ban window (31 trading days in this particular study) means that any chill in prices could conceivably be the result of just such a freak mid-western cold snap.  To mitigate for this possibility, Marsh and Niemer perform a bunch of other statistical tests.  However, none of these change their basic conclusion that the universe seems to want to unfold as it wishes - with or without short-restrictions.

The European Central Bank published it’s semi-annual “Financial Stability Review” last week and as usual, it contains some interesting observations about the hedge fund industry.

Cautious attitudes of hedge funds “detrimental to the functioning of financial markets”

Some hedge fund critics point to hedge fund “deleveraging” and hedge fund “selling” as enablers, if not the cause, of the recent market downturn.  Although selling off a market neutral portfolio has a net zero impact on markets, many hedge funds are long-bias and therefore it could still be argued that they put downward pressure on prices.  But the corollary of the hedge fund induced market crash is that hedge funds must have also been the ones supporting the market in the good time.  The December ECB report notes that hedge fund redemptions are therefore bad for markets:

“The reduced availability of leverage notwithstanding, such cautious attitudes of hedge fund managers, even if probably justified at a fund level, are detrimental to the functioning of financial markets, since they imply asset sales and deprive markets of their most active participants.”

Reduced hedge fund leverage

Whether it was self-induced or was thrust upon it, there seems to me little question that overall hedge fund leverage has been falling for quite come time.  The two charts below from the CB report show how gross exposure (of long/short funds) and overall leverage (of all funds) have both fallen over the past 18 months.  (click to enlarge)

Not the first time that really terrible performance has plagued the laggards

The report points out that while there have been plenty of hedge fund disasters (e.g. 50% drawdowns), the proportion of funds with returns in that range is about the same as the proportion in that range in 1999.  In fact, the worst 10% of funds this year has only performed a little poorer than the worst 10% of funds during the entire 1999-2003 period (left chart - click to enlarge).  The difference this time is that the mean fund (solid blue line) is way down below its 1999 lows.

Using a lack of reporting as an indicator of attrition, the ECB makes a startling observation in the right hand chart above.  While launches are way off, actually “liquidations” are actually below their long term average rates.  However, the proportion of funds experiencing some other form of “attrition” is way way up.  As a result, the 12 month moving sum of net new funds dipped into negative territory in mid-2007.  Since a disproportionate amount of hedge funds are below average size, we expect the red line to stay below zero for a year or two.

In the end, the ECB seems to concur with the Economist, which wrote in an October article that the challenge facing hedge funds isn’t deleveraging, but redemptions.

“…in the period ahead, the main challenges faced by most hedge funds will be investment performance results and the retention of dissatisfied investors. Since leverage levels did not appear to be high, the likelihood of further deleveraging is rather low. However, further sizeable position unwindings by hedge  funds due to probable higher investor redemptions and more frequent cases of hedge fund liquidation may pose a challenge to financial markets.”

To help combat public pressure on the hedge fund industry, self-regulation has been pushed to the top of the industry’s agenda over the past year.  Earlier this year, the UK’s Hedge Fund Working Group, a group of over a dozen UK-based mega-funds, published a set of voluntary guidelines governing such things as risk management and fund governance.

Soon after the release of these self-regulatory guidelines, accountancy KPMG surveyed institutional investors to see if they thought hedge funds would actually sign-up.  Nearly 90% of investors thought hedge funds should sign-on to the guidelines.  Yet only 40% felt that “the majority” of hedge funds would actually do so.

More…

While the average hedge fund is small and uses a very small amount of leverage, the average dollar invested in hedge funds is managed by a large manager who regularly uses leverage.  This state of affairs is courtesy of the significant amount of concentration in the hedge fund industry.   Most of the world’s hedge fund assets are managed by a small group of mega-managers who can shop their business around to various prime brokers in order to extract the best deal.

A new paper says that in an effort to win this business, prime brokers have been falling over themselves to offer the most leverage and the best terms.  Ergo, it is the prime brokers, not the hedge funds themselves, that require stricter regulation.  (Think: regulating mortgage brokers, not home-owners…)

By doing so, regulators can also get the prime brokers to do some of their their bidding when it comes to hedge fund oversight.  In other words, they’d essentially be informally deputizing the prime brokers.

The paper was written by Michael King of the Bank for International Settlements and Philipp Maier of the Bank of Canada.  (Note to PR departments of these organizations: Relax, the author say that “No responsibility should be attributed to the Bank for International Settlements or the Bank of Canada“.)

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It’s easy to assume that hedge funds are totally obsessed with secrecy.  In fact, one might be excused for believing that the lack of regulation and resulting lack of transparency is what makes a hedge fund a hedge fund.   In its report on the upcoming Congressional hearing involving five of the highest paid hedge fund managers, the magazine “Congressional Quarterly Weekly” (not a typo) describes secrecy as:

“…a prerogative that fund managers jealously protect in order to keep competing funds from appropriating their business strategies.”

But do hedge fund managers really rely that much on secrecy to produce their returns (as Bloomberg’s Matthew Lynn suggested in this column last year)?  Wouldn’t all managers - including ones of the long-only persuasion - also want to keep their investment ideas a secret?  NYU’s Stephen Brown questioned CQ Weekly’s assumption, telling the publication:

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The Bank for International Settlements in Basel, Switzerland is likely abuzz this week watching history unfold before its eyes.  After all, one of the lynch pins of the organization’s Basel II Accord was the requirement for banks to mark-to-market all assets - including less liquid ones.  And it appears that doing so in a leveraged environment has put several banks into a death spiral in recent weeks (see featured post below).

But the BIS is also keeping an eye on hedge fund leverage.  The organization just released a working paper called “Estimating Hedge Fund Leverage” that proposes a new method of calculating the level of leverage used by hedge funds and, it is hoped, a way to measure any resulting systemic risks to the financial system.  Regular readers may remember that this topic was also covered by the Fed’s Tobias Adrian last year (see previous story).

As the authors of this report point out, leverage comes in two basic forms: funding leverage - where you literally borrow money to goose returns (or losses) and instrument leverage - where the securities themselves have leverage baked in (such as a futures contract, option or swap).  But at the end of the day, if a fund rises twice as much as the market on “up” days and falls twice as much on “down” days, then the source of leverage is less relevant.  In fact, divining leverage based on historical returns will also capture the leverage implicit in the balance sheets or business models of individual securities.

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Climate researchers have long debated the effect of airplane contrails on the average ground temperature.  They theorized that contrails prevented sunlight from hitting the ground and warming the lower atmosphere.  But while each individual contrail could, in theory, create a slight shadow over a wide area, it was impossible to really gauge the effect of these ubiquitous clouds on the overall climate unless people literally stopped flying for several days.

Of course, this is exactly what happened during the week of September 11, 2001.  And researchers subsequently discovered that contrails did affect climate after all.  As CNN reported at the time, the average temperature volatility in the US actually rose significantly:

“During the three-day commercial flight hiatus, when the artificial clouds known as contrails all but disappeared, the variations in high and low temperatures increased by 1.1 degrees Celsius (2 degrees Fahrenheit) each day, said meteorological researchers.”

The recent moves by the SEC and FSA to curtail shorting of financial stocks provides researchers with a similarly unique opportunity to examine the effect of this equally ubiquitous phenomenon.

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A little over a year ago the International Trade Union Congress (ITUC) launched a blistering attack on hedge funds and private equity, calling them “termites” and referring to their strategies as “casino capitalism” in this report (see related post).  Warned ITUC:

“The trustees and fiduciaries of pension funds must moreover consider investments in private equity and hedge funds very carefully. Due consideration should be given to the real profitability record of such investments, the risks associated with them, the many externalities they generate, and the direct or indirect impact they may have on the workplaces of the owners of the pension plans of tomorrow.”

But despite the brewing hostility toward alternative investments exemplified by this 2007 report, pension plans continued to invest over the past year.

Now the US Government Accountability Office (GAO) has weighted in on the suitability of hedge funds and private equity for the nation’s public and private pension plans.  Its report, like so many before it, has been met with skepticism from other government bodies - turning it into the latest proposal to be bounced around Washington like a fumbled football.

In the August report, the GAO warned:

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There are few products in the world with as many confusing and contradictory marketing constraints as hedge funds in the US (and, in fairness, many other jurisdictions).  Hedge fund marketers out there know what I’m talking about.  Last month, we told you about a study that compared hedge fund regulatory regimes around the world to see if the lax ones were more popular.  Despite carrying the mantle of the free market, the US actually had a very restrictive regime when compared to countries such as Australia, Canada, Japan, and even China.

An article in this month’s Journal of Financial Transformation illustrates why this is.  The piece, titled ”Hedge fund marketing in an era of regulatory uncertainty” covers many of the issues faced by those trying to raise money in the US.  It’s a great update on the ebb and flow of SEC edicts over the past year and was co-authored by hedge fund personality James Hedges.

The article describes Congress’ response to the SE having the rug pulled out from under them on hedge fund registration back in 2004.  Sensing an opportunity after manager Phil Goldstein successfully challenged the SEC’s registration rule, Congress stepped into create a “legislative override”.  While leaving the registration issue in Congress’ capable hands, the SEC embarked on an anti-fraud rule that makes it illegal to break the law (see related posting).

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