market folly

A month or so ago, we saw that some of Obama's aides were pushing for a disclosure of hedge funds' short positions, similar to how funds disclose long positions with 13F filings. And, we thought it would be interesting to consider the pros and cons of such a maneuver.

While we would love this because it would give us even more to blog about in our hedge fund portfolio tracking series, we ultimately feel that it would be bad for the markets. Remember that massive drop-off in the markets back in October and November? Yea, part of the reason for the massive selling in certain equities was funds "front running" each other. When you 'front run,' you are basically shorting the long positions of other struggling funds that you figure they will be forced to sell. Initially, funds were forced to sell positions due to the fact that they were struggling due to weak performance and/or redemption requests. This situation was further amplified when the lions started to attack the wounded wildebeest. At the time, many funds were liquidating and/or seeing a large amount of redemptions.

Once other funds got wind of who the weak were, they went to feast. 'Only the strongest will survive.' By merely pulling up a 13F filing with the SEC or doing some poking around, you could get a general idea as to what some of that fund's largest holdings were... holdings that would typically take a few days to sell out of, if forced to liquidate. And, the front-running began.

Now, imagine a similar scenario where other funds 'front-run' weak funds' short positions. But, here's the difference: Those weak funds could only lose a finite amount of money on their longs they were forced to sell. If/when the stock goes to $0, the cycle is done. However, if a fund is short a stock and they get caught in a squeeze, they can lose an exponential amount of money (as there is no ceiling as to how high a stock can go - as recently illustrated in the Volkswagen short squeeze). So, imagine a weak fund that is short a ton of shares of XYZ company, one of their largest short positions. Everyone gets wind that they are weak and starts buying shares, squeezing the weak fund that is short, and forcing them to cover. After all, it doesn't take very long for a stock to skyrocket. The potential fund losses could be exponentially greater and trigger yet another wave of weak funds being forced to liquidate positions. The main point here is that such a disclosure could lead to even more volatility and even more chaos. There is one caveat with this theoretical scenario though: Its not as easy to figure out their short positions as it is their longs. Funds are required to disclose their long holdings to the public, but not their shorts. And, a fund's short book is often one of their closely guarded secrets. So, if you require public disclosure of such shorts, then other funds can quickly prey on the weak yet again.

This is just one tiny theoretical example, but there are many reasons to oppose this proposition. Throwing yet another wrench in the current system would give many funds pause about how they normally go about structuring their portfolios. Funds would undoubtedly try to find new, complex ways to short without having to disclose it. As we just mentioned, their short positions are often their prized secrets. And, shorting is an essential part of not only many hedge fund strategies, but also market liquidity. Remember the shorting ban? Yea, that worked well. /Sarcasm. While disclosing shorts is obviously not as extreme of a move as eliminating shorting altogether, there would definitely be repurcussions. Additionally, we wonder if disclosing the short positions could possibly have the 'Warren Buffett' effect, but in the opposite direction? Many investors piggyback Buffett's plays and when he discloses a position, the stock usually ramps up and gains more following. So, imagine a scenario where a couple of prominent hedge funds are required to disclose they are massively short XYZ company. You can bet that many people will piggyback that trade and possibly send that stock spiraling downwards. And, this is exactly what has happened in the past. For instance, take David Einhorn of Greenlight Capital. He laid out a short thesis for Allied Capital a couple of years ago at a charity investment conference one night. That next day, while other stocks opened for trading, Allied Capital remained closed because there were so many people trying to short it. Einhorn even wrote about this story and his encounter with Allied in his book, Fooling Some of the People All of the Time. The main point here is that such a disclosure proposition could have many unintended consequences and could possibly do more harm than good.

You can bet that nearly all hedge funds will be opposed to this disclosure if it will be available to the public. Most, however, have no problem revealing the positions in private to regulators. If it is revealed to the public though, that's where many hedge funds take issue. And, many prominent hedge fund managers shared this exact stance when they testified before Congress. And, we feel this is the correct move. By disclosing this information privately to regulators, we can (hopefully) have better risk management. That is, assumming, we have faith in regulators to do their job. Exactly how regulators will use this information, we're not entirely sure. But, we do know one thing: Disclosing such information to the public could potentially open a can of worms.