Hedge Fund Managers’ Short-Selling Skill

Thanks to private information and liquidity provisions, hedge fund managers may be better at short-selling than other investors, according to research.

Skeptical about your hedge fund manager’s skill? You should take a look at their short-selling records, research shows.

From a study of 53 hedge fund firms and their trades from 1999 to 2011, researchers from the University of Illinois at Urbana-Champaign and consultant Brattle Group found hedge fund managers gained higher profits on short sales than non-hedge funds.

Short sales that were covered—or repurchased—within five trading days earned an average return of 14 basis points per day, or 35% per year.

In contrast, non-hedge fund institutional investors lost an average of 10.8 basis points per day for short sales also covered within five trading days.

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“Hedge fund short-selling abnormal performance is persistent, consistent with it being due to skill, but that of non-hedge funds is not,” wrote University of Illinois’ Jaewon Choi, Neil Pearson, and Brattle’s Shastri Sandy.

In fact, funds that scored in the highest quintile on previous short trades continued to outperform in future quarters.

This persistent outperformance could be due to “informed trading” and “private information”, the authors continued.

“Hedge fund short positions opened in a short window prior to earnings announcements predict negative earnings surprises, and their short trades that are open during earnings announcement and covered within five trade dates… are profitable,” Choi, Pearson, and Sandy said.

Furthermore, hedge fund managers profited from liquidity provisions, while non-hedge funds saw no such correlation.

The researchers found their short sales kept longer than five days averaged nearly zero in returns while non-hedge fund investors earned 2.6 basis points on trades repurchased within one to three months.

Read the full paper “A First Glimpse into the Short Side of Hedge Funds”.

Asset managers have long courted the world’s largest asset allocators in hopes of landing lucrative mandates. But increasingly, managers are working to woo allocators’ gatekeepers, as well.

Investments firms have doubled down on consultant relations in recent years, ramping up both the quantity and quality of employees responsible for interacting with sector. The importance placed on consultant relationships by asset managers has nearly doubled in the last five years, according to research by Cerulli Associates. In 2011, 42% of managers surveyed rated the function as “very important.” Since then, the percentage has grown to 79%.

“What was once a nice-to-have is now a must-have,” said Chris Mason, a research analyst at Cerulli.

In the past, Mason explained, consultant relations teams might have consisted of one or two people setting up meetings between advisers and portfolio managers. Now, these units have evolved into a robust, multi-person departments armed with CFAs and investment expertise, their sole purpose to make nice with consultants.

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“These are dedicated people who spend the entire day calling on and trying to set up meetings with these consultants,” Mason said. “Asset managers are relying on their consultant-relations professionals to be able to speak to the particular nuances of their strategies and have more of an investment background.”

Managers have invested so much in these teams, Mason continued, that many consultants feel overwhelmed by the sheer number of incoming meeting requests from asset managers.

So what’s prompted this sudden consultant relations arms race?

Consultants themselves are not new. Use of an independent investment adviser—particularly for public pension funds—has been an industry norm for several years. Consultants intermediate the vast majority (86%) of US-based institutional investor-provider relationships, and have done so for years, according to Greenwich Associates.

“One of the reasons we haven’t seen a meaningful drop-off in consultant usage is every year there are new and different challenges,” said Sara Sikes, vice president of Greenwich Associates’ investment management practice. “As a result, institutional investors still rely heavily on experts with deep knowledge of the issues to provide advice and guidance.”

In particular, Sikes said asset owners rely on the “breadth and depth” of knowledge consultants bring to manager selection. Most allocators don’t have the internal resources necessary to evaluate every potential asset manager, she argued.

“In many cases, they don’t feel well armed to make the decisions on their own,” Sikes said. “They feel more comfortable having a consultant advising on the decision.”

The relationship makes sense: Consultants have the capacity to research a wide range of managers, as well as insight into what strategies might work best for a particular fund based on their experience advising other asset owners. The trade-off is that consultants end up with a significant amount of influence—so much that any manager pursuing an institutional mandate likely has to go through a consultant first.

Cerulli data show that 58% of net flows to asset managers were consultant-intermediated in 2015. Yet according to Greenwich Associates, consultants endorse a tiny number of firms. Roughly 3% of US equity managers and 8% of fixed income managers make the buy-lists.

To have a chance at institutional money, managers need to get on those elite lists. And to get on those lists, they have to “put their best foot forward,” Mason said.

“In order to target these consultants and get in front of them and educate them on their strategies, they need to have a dedicated team on staff,” he said.

Yet the more managers bulk up their consultant-relations teams, the more skewed the ratio of advisers to lobbyists becomes. And the more relationship professionals per individual consultant, the more people there are competing for an individual’s time.

“As institutional asset managers continue to build out these consultant relations teams, the effect is that it’s been extremely difficult for managers to get in front of consultants and target them,” Mason said.

And so the arms race continues. Over the next three years, 89% of surveyed managers said consultant relations will be “very important,” according to Cerulli.

“If you want to play in the institutional space, consultant relationships are a must-have,” Mason said.