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.

“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”.