By Daniel Stern, Cliffwater LLC
There has been much speculation this year on
the difficulty equity long/short managers have been having shorting stocks. In fact, a number of managers tracked by Cliffwater have commented on the challenges of shorting stocks with high short interest which have dramatically outperformed the broader markets. Goldman Sachs maintains a list of the top 50 stocks with market capitalizations greater than $1 billion which have the highest short interest as a percentage of market capitalization. This year through August these stocks have gained over 26% on average, which is much higher than the 16% gain for the S&P 500 and the 9% gain for the MSCI ACWI Index.
Managers have likened the current investment environment for short selling to periods such as 1992/3 which were characterized by investors chasing “story stocks” and bidding up troubled companies, 1996/7 when day traders used online “chat boards” to pump shares of high momentum stocks similar to the current use of social media to help induce short squeezes, and to the internet bubble in the late 1990’s which was fueled by loose monetary policy. Importantly, these periods were all followed by more profitable environments for short selling.
In addition, while the current environment has been challenging for managers in general, equity long/short managers on Cliffwater’s Select List have been able to add alpha from their short portfolios relative to the S&P 500 index. As the exhibit above shows, year-to-date through July these managers have generated an average return on invested capital in their short portfolios of -12.2%, which is significantly higher than the inverse return of the S&P 500 of -17.1%, although below the -10.6% inverse return of the MSCI ACWI Index.
Managers have also been able to keep up with the rally in their long portfolios, as evidenced by the average return on
invested capital in their long portfolios of 19.7% year-to-date through July, relative to the S&P 500 return of 19.6%
and MSCI ACWI Index return of 11.1%. In sum, while the recent environment has been challenging for short selling,
managers have still been able to add alpha in their portfolios. Going forward, Cliffwater anticipates managers will have ample opportunity to generate short side alpha once the strong upward momentum in the markets tapers off.