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Short strategy in a hedge fund

14 March 2016
Short sellers borrow shares and sell them on the market with the idea of buying them back later at a lower price. To short sell a stock, it is necessary to borrow it from a broker and immediately sell it on the market; then you have to deliver the stock back to the counterparty by buying the same amount of shares later on the open market. If the repurchasing price is lower than the initial selling price there is a profit, otherwise the manager will suffer a loss. Short sellers also make money from the liquidity interest originating from selling the stock short, a liquidity which is held as restricted credit by the brokerage company lending the shares: the short seller will earn interest on these cash proceeds, called short interest rebate.
In his book Devil Take the Hindmost: A History of Financial Speculation, Edward Chancellor suggests that the first case of short selling took place in 1609, when the Dutch merchant, Isaac Le Maire, organized short sales on stocks of the Dutch East Indies Company VOC listed on the Amsterdam Stock Exchange. In 1610, the VOC directors convinced the Dutch States-General to declare short selling illegal because bearish speculators were “incommensurably damaging innocent shareholders, among which are widows and orphans”. Since the illegal activities continued anyway, instead of forbidding them, in 1689 the Dutch government decided to levy a tax on profits from short sales. In 1949, Alfred Winslow Jones, a former reporter for Fortune, created the first hedge fund. He raised $100 000 and started managing an equity fund. The fund was structured as a partnership to avoid SEC controls and to retain maximum flexibility when setting up the portfolio. His strategy was to combine long positions on undervalued shares with short positions on overvalued shares. Thus, short selling became the keystone of the first hedge fund and of all the ones to follow. 
This brief historical overview clearly indicates that short selling has long been a controversial practice on capital markets. The dislike for short sales is recurrent and gets worse every time markets are hit by panic or by falling prices. The moral diffidence against this practice and the fear it might engender a market disturbance has prompted numerous attempts to prohibit or limit short selling. Despite this dislike and diffidence against short sales, many studies show that short sellers actually favor the stabilization of falling markets, because you need to buy in the borrowed shares to close out short positions, while short sales provide liquidity to the market when there is a dearth of buyers.
According to the LIPPER TASS database, as of 31st December 2004, out of a total of 2361 hedge funds there were 18 hedge funds, both on-shore and off-shore, following a “dedicated 30 Investment Strategies of Hedge Funds short bias” strategy. To date, hedge funds specializing exclusively in short selling are rather rare and many of them switched to a long short equity strategy with a net short position, or short bias.
A myth that should be exploded is that these funds are the cause of market crashes: as of 31st December 2004 these funds accounted for about 0.24% of total hedge funds. At the end of 2004 the hedge fund industry had estimated assets under management of about $1275 billion. The estimated capitalization of US equity markets is approximately $20 000 billion: this means that the weight of these funds on world equity markets is 0.015 %. These figures by themselves are evidence that short-only hedge funds cannot possibly be the cause of crashing equity markets.

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