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Short-Selling, the SEC, and Your Long-Short Fund

What the new short-selling regulations mean for long-short mutual funds.

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It's mayhem out there. With painful losses coming from nearly every fund category, plenty of investors are pulling their hard-earned money out of the market. Long-short funds, however, are one exception to that trend. For the year to date, they've garnered another $6.3 billion, likely in response to their defensive strategies.

There's no easy way to categorize these funds, given the many different strategies that they practice, but it's fair to say that most short-sell stocks with a portion of their portfolios. A short-sell is essentially a bet that the stock price will fall. An investor borrows a stock, sells it, and later buys it back, if all goes according to plan, at a lower price. So, the touted advantages of a long-short fund that employs this strategy are its ability to place bets on the stocks that the management team (or its quantitative model) doesn't like and its potential to profit--or at least lose less--when the rest of the market falls.

Not surprisingly, in the current down market, many long-short funds have held up much better than the traditional long-only variety and the broad market. The S&P 500 Index and the typical large-blend fund have lost more than 15% since the credit crisis gained steam last July. Long-short funds, on average, have fallen 7.3%.

It would seem, given those returns, that shorting is a valuable tool in a market where fundamental problems cause bankruptcies, takeovers, bailouts, or, at the very least, falling stock prices. But some charge that short-sellers actually cause some of these problems. The critics allege short-sellers either fuel false rumors to push stocks lower or simply pile on crumbling institutions and drive them to bankruptcy. The idea is that, by placing bets against an investment bank, short-sellers acting in mass can undercut investor confidence. Once investors lose confidence in a company, its share price can drop precipitously, to the point where it is no longer soluble.

With Lehman Brothers failing early last week and concerns about  Morgan Stanley (MS) and  Goldman Sachs (GS) building in the days following, these arguments spurred the SEC to take regulatory action. On Wednesday, Sept. 17, the SEC announced temporary rules aimed at curbing the consequences, nefarious or otherwise, of short-selling. Institutions must now report their short positions weekly, and "naked short-selling," or the practice of shorting stocks to which the investor doesn't have access, is curtailed until Oct. 2. The next day, the SEC took stiffer precautions, announcing that, at least until Oct. 2, short-sellers can't short roughly 800 financial stocks.

What Does It All Mean?
At first blush, it might sound like the long-short gig is up. After all, if long-short funds can't short the most tumultuous sector in the current market, what's the point? A closer look, however, reveals that's not quite the case. For starters, naked short-selling has never been a prevalent practice in the mutual fund industry; many long-short funds come from big institutions, so the managers have access to most of the stocks that they want to short anyway. And while a few institutions have stopped lending securities to short-sellers and other borrowers, it is far from an industrywide move at this point. The weekly disclosures are a bit more cumbersome and may cause friction with company management teams that don't like to see funds bet against their stocks, but they don't prevent the fund managers from executing their trades. Finally, the ban on financial short-selling doesn't mean that the managers can't keep their current bets in place; it simply means they can't institute new ones. That causes some problems for long-short managers. They can't increase their short positions in financials to accommodate new money, for example, or short a bank that didn't look weak a month ago. Even so, these difficulties don't force long-short managers to abandon their strategy.

A Longer-Term View
The longer-term implications of the new SEC regulations aren't quite as clear. This is the second time in the past few months that the SEC has temporarily stiffened regulatory oversight of short-selling (in July it sought a nine-day reprieve from naked short-selling for 19 financial stocks), and should the markets continue to tumble, it might do so again, perhaps for a longer period of time. That possibility introduces some uncertainty here. Moreover, some investors are calling for the reinstatement of the Uptick Rule, which was abolished in July 2007. The Uptick Rule required stocks to advance at least a fraction higher before investors could sell them short. That would prevent short-sellers from piling on a company in free-fall, but critics of the rule say it doesn't have a meaningful impact on short interest in companies. They also claim that it is hard to enforce across trading platforms and exchanges that are saddled with varying degrees of regulation.

The Takeaways
Even given these uncertainties, we don't think the basic approach of long-short funds is at risk at this point. The regulations may intensify, but unless managers are permanently prohibited from making short sales, these funds can continue their operations.

Nevertheless, the regulatory crackdown highlights what we've been saying all along: Short-selling introduces risks not common to traditional investing. Thus, we prefer management teams with proven shorting skills and reasonable operations and procedures in place so that they can better adapt to market movements and changing regulatory environments. We continue to highlight  Diamond Hill Long-Short (DIAMX) and  Calamos Market Neutral Income (CVSIX) as funds that have our confidence in those regards. 

Marta Norton does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.