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Jones and Glen Larsen Short Selling in Efficient Portfolios: The Theory and Its Practical Implications 207 The Empirical Evidence on Short Positions in Ex Post Short Sales: Reporting, Fre

Short Selling

Strategies, Risks, and Rewards

FRANK J FABOZZI

EDITOR

John Wiley & Sons, Inc.

Short Selling

THE FRANK J FABOZZI SERIES

Fixed Income Securities, Second Edition by Frank J Fabozzi

Focus on Value: A Corporate and Investor Guide to Wealth Creation by James L

Grant and James A Abate

Handbook of Global Fixed Income Calculations by Dragomir Krgin

Managing a Corporate Bond Portfolio by Leland E Crabbe and Frank J Fabozzi Real Options and Option-Embedded Securities by William T Moore

Capital Budgeting: Theory and Practice by Pamela P Peterson and Frank J Fabozzi The Exchange-Traded Funds Manual by Gary L Gastineau

Professional Perspectives on Fixed Income Portfolio Management, Volume 3 edited

by Frank J Fabozzi

Investing in Emerging Fixed Income Markets edited by Frank J Fabozzi and

Efstathia Pilarinu

Handbook of Alternative Assets by Mark J P Anson

The Exchange-Traded Funds Manual by Gary L Gastineau

The Global Money Markets by Frank J Fabozzi, Steven V Mann, and

Moorad Choudhry

The Handbook of Financial Instruments edited by Frank J Fabozzi

Collateralized Debt Obligations: Structures and Analysis by Laurie S Goodman

and Frank J Fabozzi

Interest Rate, Term Structure, and Valuation Modeling edited by Frank J Fabozzi Investment Performance Measurement by Bruce J Feibel

The Handbook of Equity Style Management edited by T Daniel Coggin and

Measuring and Controlling Interest Rate and Credit Risk: Second Edition by

Frank J Fabozzi, Steven V Mann, and Moorad Choudhry

Professional Perspectives on Fixed Income Portfolio Management, Volume 4 edited

by Frank J Fabozzi

The Handbook of European Fixed Income Securities edited by Frank J Fabozzi

and Moorad Choudhry

The Handbook of European Structured Financial Products edited by Frank J

Fabozzi and Moorad Choudhry

The Mathematics of Financial Modeling and Investment Management by Sergio M

Focardi and Frank J Fabozzi

Short Selling

Strategies, Risks, and Rewards

FRANK J FABOZZI

EDITOR

John Wiley & Sons, Inc.

Copyright © 2004 by John Wiley & Sons, Inc All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey

Published simultaneously in Canada

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10 9 8 7 6 5 4 3 2 1

CHAPTER 1

Introduction 1 Frank J Fabozzi, Steven L Jones, and Glen Larsen

vi Contents

CHAPTER 4

Is Selling ETFs Short a Financial “Extreme Sport”? 37 Gary L Gastineau

What Are the Most Important Safety Features

Protecting ETF Short Sellers? 38

How Do ETFs Work in Risk Management Applications? 39

Will It Always Be Possible to Borrow ETF Shares at

Low-Cost for Risk Management Applications? 47

What Is the Effect of Short Selling and Risk Management

Activity on ETF Trading Volume and Trading Costs? 49

Are Risk Management Applications and Heavy ETF Share TradingDesirable for Fund Shareholders and Fund Advisors? 51

What Is the Significance of the Short Interest for

Growth in ETF Assets? 52

Demand and Supply Curves Arguments 62

The Pattern of Stock Prices Over Time with

Short Sale Constraints 180

The Overpricing Hypothesis 184

Contents vii

CHAPTER 8

How Short Selling Expands the Investment Opportunity Set and

Improves Upon Potential Portfolio Efficiency 205 Steven L Jones and Glen Larsen

Short Selling in Efficient Portfolios: The Theory and

Its Practical Implications 207

The Empirical Evidence on Short Positions in Ex Post

Short Sales: Reporting, Frequency, and Constraints 235

Academic Theory versus the Technical Analyst’s View 236

The Empirical Evidence 239

Conclusions and Implications for Investors 253

SECTION THREE

Short Selling Strategies 257

CHAPTER 10

Ron Gutfleish and Lee Atzil

Looking for the Easier Fight 260

Putting on the Green Eyeshades 261

So What? It’s Only Accounting 265

How Do You Find these Cases? 266

Keeping Your Shorts On 270

Tales from the Front Lines: Three Examples 271

CHAPTER 11

The Economic Profit Approach to Short Selling 279 James A Abate and James L Grant

Short Selling in the Theory of Finance 280

Tenets of Good and Bad Companies 280

Positive NPV: Discovery of Good Companies 281

Negative NPV: Discovery of Bad Companies 284

Zero NPV: Wealth Neutral Companies 287

Role of the Value/Capital Ratio 291

Invested Capital Growth 292

Managerial and Investor Implications 294

viii Contents

Matrix of Good and Bad Companies 295

Reconciling Market Implied Growth 298

CHAPTER 12

Long-Short Equity Portfolios 303 Bruce I Jacobs and Kenneth N Levy

Constructing a Market Neutral Portfolio 304

The Importance of Integrated Optimization 308

Adding Back a Market Return 312

Some Concerns Addressed 316

Short Sales Restrictions Around the World 325

Foreign Listing and Short Selling 331

Short Selling Constraints and International Capital Flows 339

Foreword

Short selling is un-American It is done by rogues, thieves, and especiallypessimists, who are, of course, the worst of the lot It is a terrible, terriblething and must be stopped in our lifetime We should halt it, restrict it, or

at the very least revile those who make it their vocation

The above sentiments are sadly not imaginary or rare Rather, theygenuinely reflect much of the investing public’s view of short selling Infact, attacks have included proposals to make short selling harder (theexisting “uptick rule” already makes it hard), or to make it impossible bybanning it outright (presumably along with pessimism itself, and perhapsthe infield fly rule) These criticisms and draconian proposals all increase

in volume and seriousness when the stock market goes through a toughtime At such times many claim short sellers are the cause of the market’sdecline Finally, at the low point for stock prices, many members of Con-gress invariably reexamine whether shorting should be allowed, or moresimply, consider just legislating that the Dow go up 50 points a day

Of course, the media does not help A rising stock market is a goodthing for ratings and circulation This country is, of course, biasedtoward rooting for stocks to go up, and people watch and read moreabout this stuff when it is fun (i.e., going up) Thus, short sellers, withtheir gloomy attitude, are not generally media friendly In fact, even

some pro-free enterprise media outlets sometimes throw away their

lais-sez faire stance when it comes to short selling, particularly “in times of

crisis” (defined as an overvalued market getting a bit less overvalued).Apparently, they have some confusion regarding the difference betweensupporting a free capital market versus supporting an expensive one.Well, to sum up the theme of this foreword, opponents of short sell-ing are not merely wrong They are incredibly wrong, both factually andmorally Short sellers are among the heroes of capitalism and we owethem our thanks not our opprobrium The opponents of short sellingare either exceptionally economically challenged, or run to a naturaltendency to ban anything they do not like There’s a word for the politi-cal system favored by people like that and it is not democracy (but doesrhyme with Motalitarianism)

x Foreword

Extensive theory may be helpful, but it is not necessary, to stand why the ability to implement a pessimistic view (e.g., to sell short)improves market efficiency and thus makes the market safer for all par-ticipants Without short selling, prices are in a sense uncapped As valu-ations get excessive the only way to express a negative view is to go on abuying strike It is analogous to a voter who disliked the incumbent, butfound the only option was to stay home, as voting for the challengerwas prohibited (again, we have seen systems like that in the world, but

under-we are just not supposed to have one here) It seems quite intuitive that

if we restrict the ability to express pessimistic views, prices will on net

be biased towards the optimistic outlook Of course the goal of efficientfinancial markets is to have prices reflect our collective best guess, some-where between optimistic and pessimistic It follows that overpricedstocks and stock markets, including incredibly destructive bubbles, arebest fought by allowing all opinions to affect prices For instance, therecent market/tech bubble would in all likelihood have been less egre-gious with fewer hurdles to short selling To put it simply, widows andorphans are on net protected, not damaged by short sellers Of course,for this all to be true, short sellers must, as most of them claim, be fol-lowing rational strategies and not following the same wild momentumstrategies as others just on the short side

Luckily, short sellers as a group, at least according to the reportedhedge-fund indices, do what they say they do A simple study of theirreturns makes it clear they are net short stocks.1 If this seems less thanrevelatory, consider that doing what you say you are going to do is not

1 Using the short selling index from CSFB/Tremont and returns on the S&P 500, and value-growth stocks and small-large stocks (HML and SMB from Professor Ken French’s website http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/ respec- tively) run the following regression (all returns are either on long/short portfolios or excess over cash) monthly from 1994–2003:

CSFB Short return

= intercept + β1 × S&P 500 + β2 × [value-growth] + β3 × [small-large]

Running this regression leads to t-statistics on the betas of –16.4 (S&P 500), +3.1 (value-growth), and –7.4 (small-large) with an adjusted R-squared of 76.7% Next

add one additional term to capture a potentially changing market beta through time This is an “interaction” term representing this month’s S&P 500 times the S&P 500’s return over the prior year If this comes in with a positive (negative) slope it means that short sellers ran a higher (lower) market beta after rolling years that the

market went up Its t-statistic is –2.65 (so short sellers get shorter after market rallies)

with the statistical significance of the other factors unchanged (though the

value-growth t-statistic falls to a still significant +2.09, perhaps as this dynamic beta

cap-tures part of the time pattern of value’s return).

fbetw.frm Page x Thursday, August 5, 2004 10:42 AM

Foreword xi

always a slam dunk in today’s capital markets More novel, shorts arebiased to get shorter when the market has been strong, that is, in aggre-gate they fight a market trend.2 They are biased to short smaller thanaverage stocks and, perhaps most importantly, to short expensivestocks In a world that often feels dominated by momentum investingand one-way market cheerleading, they are short They get more shortwhen the market goes up and less when it falls And, when it comes tostock selection, they are most short the most expensive growth stocks.While individual short sellers might differ, in aggregate, they are notshorting distressed companies to drive them to doom with misleadingInternet chat Rather, in aggregate, short sellers are the PraetorianGuard of the financial markets These activities logically, and in fact, lead

to a more stable market where bubbles (both in aggregate and in relativevalue) are fought by the short sellers (though as 1999–2000 shows, notnecessarily fought enough), and not, like done by much of the rest of theinvesting world, simply ridden until the eventual ugly denouement Why do they do it? Consider the hurdles short sellers face Stocks, onaverage, rise over time This is both an empirical fact and a theoreticallymandated occurrence The long-run equity risk premium is positive Shortsellers swim against this tide, taking their capital and betting against

“stocks for the long run.” Second, short sellers bet against the idea thatmarkets are efficient While some of the returns to short selling can beconstrued as just picking up a value premium which may be rational,clearly the shorts themselves believe they are taking the rational side in anirrational world Also, the specific stocks they short, tend to be ones pre-vailing wisdom favors, nay adores, and in the early days of a short posi-tion they are often laughed at (with the last laugh often forgotten) Furthermore, the risks of shorting may be greater than other invest-ments Some used to laugh at the common observation, “Don’t shortbecause you can lose an infinite amount of money.” Then 1999 camealong and proved the “fools” uttering this statement were not so wrong.Truth be told however, the infinite loss possibility argument is still a bitsilly, as a diversified portfolio of shorts is definitely amenable to riskcontrol But, it would be disingenuous not to acknowledge that shortinginvolves some risk control challenges beyond those of traditional long-only management

Finally, successfully utilizing short selling does not just involve ing stocks that will ultimately fall, but convincing your investors to stickwith you when you are too early, and your portfolio of shorts movesfrom 2× to 4× overvalued Short sellers, by definition, tend to lose when

pick-2 Probably meaning their feelings about valuations dominate any effect from getting

“squeezed” which might lead to them moving to less short after strong markets fbetw.frm Page xi Thursday, August 5, 2004 10:42 AM

xii Foreword

most others are winning, and lose even more when this is happening inthe context of an irrational bubble (as they get much shorter in the mostovervalued names) In principle, this should be the most palatable timefor a rough patch, as diversification is half the point of a short or marketneutral investment But, it just does not work out that way When youlose and others are mostly winning, you have to defend yourself fromthe charge that you are foolish, that you have lost your edge, that whatused to work does not work anymore because it is a “new world,” orput more eloquently, “You stink, let us out of our lockup please.”

So, why do they do it? Greed, in the best capitalistic sense, is ofcourse part of it They believe enough in their skill at identifying theovervalued, the frauds, and the scams, that over the long run they will

be more than compensated for the many hurdles they face But, whilenot completely fungible, many or most of the skills in successful short-ing work on the long-only side as well, with none of the hurdles above

So why do they choose short selling? Well, like many who excel in anyfield, you will find the short sellers choose short selling partly becausethey have no choice When they see the public fooled into buying over-valued nonsense, when they see fraud perpetrated without retribution,and when they see hucksters lauded by a stock market dying to anointthe next emperor without clothes, they have no choice but to fight Theyfeel a personal affront at the overvalued going up day after day, andbubble-vision covering it in breathless admiration They feel they must

do something about it Ultimately, the shorts are in it to make money,but if they can do that while being right when everyone else is wrong(and actually help right a wrong) more the better People acting in theirown interest, but also making the world better Kind of how capitalism

is supposed to work no?

That brings us to this book, which is something special It is not acoincidence that this book wasn’t published in late 2002/early 2003when so many hastily scribed, rush-job books on shorting came out atthe nadir of a bear market These works were light on the content, andheavy on the “You too Can Get Rich by Shorting” sentiments, generally

including a couple of “if you had only shorted blank at blank price you

would have made blank by now.” This book is different The quality ofthe authors, a collection of learned and respected academics and practi-tioners, speaks to that, as does the coverage, scope, and seriousness ofthe topics This is not about getting rich quickly It is about how short-ing works, what short sellers actually do, how shorts uncover the over-valued and the true ponzi schemes, economically why short selling isimportant, the true impediments to shorting, and a host of other sober,vital, and often neglected topics It is not just about the canonical short-only manager uncovering fraud and overvaluation as implicitly

Foreword xiii

described above, it is also a detailed description of how shorting can bepart of an overall optimal portfolio, and can be pursued in all differentforms with all different types of managers (a systematic market-neutralmanager, a generally long manager who uses shorts to reduce risk andhopefully add alpha, or a truly dedicated short manger)

This book not only pulls together much of the scattered literature

on short selling, but also adds dramatically to our body of knowledge It

is not a “get rich quickly by shorting” book But, reading this bookmight help you become a better investor, as I believe it has done for me.And, if there is a better way than this to get rich slowly, or at least tostay solvent by avoiding scams, it has yet to be discovered

Clifford S Asness

Managing and Founding Principal AQR Capital Management, LLC

Preface

Short Selling: Strategies, Risks, and Rewards provides the most recent theoryand empirical evidence on the practice of short selling The chapters in thisbook, contributed by leading practitioners and academics, explain not justthe complex mechanics of short selling and the associated risks, but alsowhy some stocks can be expected to become overpriced, strategies forexploiting overpricing, and how short selling can improve portfolio perfor-mance and market efficiency Each chapter contains information relevant toboth institutional and individual investors who are currently using or may

be contemplating using short selling as a part of their investment ment strategy

manage-I wish to express my deep gratitude to the contributors of this book

A special thanks to Edward Miller who contributed three chapters ering the underlying theory on why markets become overpriced (theory

cov-of divergence cov-of opinion) and the implications for investment ment when there are restrictions on short selling

manage-This book could not have been completed without the assistance ofSteven Jones and Glen Larsen In addition to their contribution of threechapters to the book, they reviewed all chapters in the book, suggested theorganization of the chapters, and identified several contributors

Robert Krail of AQR Capital provided helpful comments on selectedportions of the manuscript

I am grateful to Clifford Asness for reading the page proofs and viding the foreword

Frank J Fabozzi

About the Editor

Frank J Fabozzi, Ph.D., CFA, CPA is the Frederick Frank Adjunct Professor

of Finance in the School of Management at Yale University Prior tojoining the Yale faculty, he was a Visiting Professor of Finance in the SloanSchool of Management at MIT Frank is a Fellow of the International Cen-

ter for Finance at Yale University, the editor of the Journal of Portfolio

Management, a member of Princeton University’s Advisory Council for

the Department of Operations Research and Financial Engineering, and

a trustee of the BlackRock complex of closed-end funds and GuardianLife sponsored open-end mutual funds He has authored several books

in investment management and in 2002 was inducted into the FixedIncome Analysts Society’s Hall of Fame He earned a doctorate in econom-ics from the City University of New York in 1972

Contributing Authors

James A Abate GAM USA Inc

Lee Atzil Elm Ridge Capital

Arturo Bris Yale School of Management

Jeff Cohen Susquehanna Intl Group, LLLP

Frank J Fabozzi Yale School of Management

Gary L Gastineau ETF Consultants LLC

William N Goetzmann Yale School of Management

James L Grant JLG Research

Ron Gutfleish Elm Ridge Capital

David Haushalter Susquehanna Intl Group, LLLP

Bruce I Jacobs Jacobs Levy Equity Management

Steven L Jones Indiana University, Kelley School of Business

— Indianapolis Owen A Lamont Yale School of Management and NBER Glen Larsen Indiana University, Kelley School of Business

— Indianapolis Kenneth N Levy Jacobs Levy Equity Management

Edward M Miller University of New Orleans

Adam V Reed University of North Carolina at Chapel Hill Ning Zhu University of California, Davis

CHAPTER 1

1

Introduction

Frank J Fabozzi, Ph.D., CFA

Fredrick Frank Adjunct Professor of Finance

School of ManagementYale University

elling a long position is the most obvious means of avoiding losses inwhat is perceived to be an overpriced asset Short selling, on theother hand, offers a means not just to avoid losses but also to profitfrom knowledge of overpricing Although the opportunity to short sell

is not new, the surge in hedge funds, many of which used short selling toprofit in the bear market, has focused renewed attention on the subject

In fact, many believe that the competition for alpha will force pensionfunds to relax the “no-short” constraint on their active managers.1 Butfor many investors, short selling remains an obscure, even mysterioussubject, seemingly more akin to art than investment science

1

See Bob Litterman, “The Active Risk Puzzle: Implications for the Asset

ment Industry,” The Active Alpha Investing Series (Goldman Sachs Asset

Manage-ment, March 2004).

S

2 SHORT SELLING: STRATEGIES, RISKS, AND REWARDS

This book reflects the most recent theory and empirical evidence onthe practice of short selling The chapters that follow explain not just thecomplex mechanics of short selling, but also why we might expect somestocks to become overpriced, strategies for exploiting overpricing,including the use of derivatives, and how short selling can improve port-folio performance and market efficiency Each chapter contains informa-tion relevant to both institutional and individual investors who arecurrently using or may be contemplating the use of short selling as a part

of their investment management strategy Special emphasis is placed onthe risks associated with short selling For example, short selling is gen-erally viewed as more risky than long investing because prices can always

go higher, which implies unlimited losses for a short position

This book is divided into four sections Section One covers themechanics of short selling The mechanics are relatively complex com-pared to a normal buy transaction In Chapter 2, Jeff Cohen, DavidHaushalter, and Adam Reed explain how short selling, or shorting, astock in the cash market involves selling a stock that you do not own.The shorted stock is borrowed through a broker and sold in the openmarket with the proceeds from the sale placed in escrow Some institu-tional investors may earn “rebate” interest on these escrowed proceeds.Returning the borrowed shares satisfies the loan; hence, the short sellerprofits from a decline in price by “selling high and then buying low.” Inorder to short sell, you must have a margin account and your brokermust be able to locate the shares to loan you The short seller faces therisk that the borrowed shares may be recalled by the lender early (recallrisk), as well as the risk of being caught in a so-called “short squeeze,”where price spikes due to price pressure from too many shorts attempt-ing to cover (i.e., buy back the stock) at the same time

There are alternatives to selling short in the cash market An investorseeking to benefit from an anticipated decline in the price of a stock,broad-based stock market index, or narrow-based stock market index(e.g., a sector or industry) may be able to do so in the futures or optionsmarkets Selling futures has several advantages to selling short in thecash market Buying puts and selling calls are two ways to implement ashort-selling strategy in the options market There are trade-offs betweenbuying puts, selling calls, and borrowing the stock in the cash market inorder to sell short The relative merits of using futures and options forshort selling, along with a review of futures and options and their invest-ment characteristics, are covered by Frank Fabozzi in Chapter 3

In Chapter 4, Gary Gastineau describes how short selling traded funds (ETFs) can mitigate the risks associated with shorting indi-vidual stocks For example, it is essentially impossible to suffer a shortsqueeze in ETF shares because the number of shares in an ETF can be

exchange-Introduction 3

increased on any given trading day A second advantage is that the

“uptick” rule does not apply to ETFs On the NYSE exchange, this rulemeans that a short sale may only be done on an uptick or a zero-plustick; that is, a price that is the same price as the last trade, but higher inprice than the previous trade at a different price On the NASDAQ, youcannot short on the bid side of the market when the current inside bid islower than the previous inside bid (a downtick) A third advantage thatGastineau discusses relates to hedging with ETF shares instead of deriv-ative contracts Derivative contracts have limited lives The most activecontracts in any futures market are the near month and the next settle-ment after the near month Equity index futures contracts will usually

be rolled over about four times a year in longer-term risk managementapplications While risk managers could take futures positions withmore distant settlements, liquidity is usually concentrated in the nearestcontracts Consequently, risk managers typically use the near or nextcontract and roll the position forward as it approaches expiration ETFshares allow for a hedge of indefinite length without “roll risk.” The five chapters in Section Two cover the theory and evidence onshort selling In Chapter 5, Edward Miller points out that restrictions

on short selling mean that prices are often set by the most optimisticinvestors, with little limited trading opportunities for the less optimisticinvestors, other than to sell there holdings The result is potential over-pricing in some stocks The opportunity to short sell such overpricedstocks is exploitable only when the overpricing is due to factors that arelikely to be revealed in the relatively near future Possible opportunitiesarise from optimistic errors such as extrapolating growth too far in thefuture, not allowing for new entry or market saturation, or just omittinglow probability adverse events from expectations

Miller builds on these points in Chapter 6 by arguing that a stantial divergence of investor opinion about a stock implies a negativeexpected return This is because restrictions on short selling preventunfavorable opinions from being fully reflected in stock prices There-fore, with restricted short selling, divergence of opinion tends to raiseprices, and profits can be improved by avoiding stocks with high diver-gence of opinion, especially those analysts disagree about Miller furtherdemonstrates that because risk correlates with divergence of opinion,the return to risk, both systematic and nonsystematic, is less than whatinvestors would otherwise require This leads Miller to suggest that typ-ical investors should overweight the less risky stocks in their portfolio.Owen Lamont provides evidence of overpricing by showing thatstocks with high short sale constraints tend to experience particularlylow returns in the future in Chapter 7 Lamont also reviews specificcases where extremely high short-sale constraints led to extremely high