As some Asian countries rushed to restrict short selling last month to support plunging share markets, the first reaction in the alternative investment world was panic. “People were running around like headless chooks [chickens],” says one Australian hedge fund sales manager in Hong Kong.
Australia banned naked short-selling, when investors sell shares they neither own nor have borrowed, and tightened disclosure rules for covered shorting, when sellers have borrowed the shares they are selling.
South Korea, which had already disallowed naked short sales, banned shorting of all local stocks without saying when the restrictions would be lifted. Indonesia, which only allowed shorting of 50 major companies anyway, forbade the practice during October.
“These bans on short selling will distort markets,” says Paul Smith, a director of the hedge fund incubator Triple-A Partners in Hong Kong. “They will create anomalies that people will exploit for profit.”
“They are only partial as [in Korea], they don’t cover the futures market,” he says. Plus, they seemed to have done little to halt the fall in Asian markets.
“I’m in the camp of thinking [regulators and politicians] are treating the symptom and not the cause. Any doctor would tell you that’s bad medicine.”
The worry is that temporary limitations show some signs of becoming more politically acceptable and entrenched as the region’s stock markets remain jumpy.
The FTSE Asia Pacific index has been one and a half times more volatile over the past two weeks than during any 10 days of trading during the depths of the Asian financial crisis a decade ago.
Taiwan last week extended a fortnight-long ban to last until the end of the year, although the island’s stock market continued to fall in line with the rest of the region.
“Volatility plays into the hands of regulators who want to maintain restrictions,” says Kent Rossiter, head of trading at RCM Asia Pacific, part of Allianz, in Hong Kong.
Asia-focused long-short funds have grown rapidly along with the hedge fund industry in the region over the past few years, and account for about half of the assets managed alternatively.
A common strategy is to look for pairs of stocks that traditionally have closely followed each other’s movements – often from the same sector – but have recently diverged in performance. The manager buys one and shorts the other, betting that the correlation will rise again to historical levels.
This year has not been kind to managers using this strategy in Asia. Eurekahedge listed 13 fewer long-short funds by the end of September, and assets had shrunk to $73bn (£42bn, €54bn), from $97bn at the end of 2007.
RCM runs an Asia Pacific ex-Japan long-short fund, as well as sector funds, out of the Asian office. Its 130/30 fund structure allows managers to short an unfavoured stock, rather than merely underweighting it, and use the proceeds to invest extra money in the stocks expected to perform best.
That is, if they can find stocks to short in Asia. “Our whole volume has been curtailed because the long-short fund can’t go long if it can’t go short on stocks,” Mr Rossiter says.
Identifying stocks to short usually takes as much effort as finding those to go long, he says. Then there is the issue of finding lenders.
“My sense is that some investment management firms are scaling back their stock lending activity,” he says.
Lenders of stocks were becoming wary about letting people borrow shares, just in case they were not returned, he says, in an echo of banks being afraid to lend money on the interbank markets.
Convertible arbitrage is another hedge fund strategy that is difficult when opportunities to short are curtailed.
Issuance of convertible bonds – which can be exchanged for shares – surged in Asia earlier this year as cash-strapped companies delayed or cancelled flotations because of falling stock markets, but found they could not borrow from banks as easily as the credit crisis deepened.
By giving bond buyers the chance to convert bonds into shares of the company at a later date, issuers are, in effect, granting investors a cheap call option that can be exercised at a profit if equity markets recover.
Convertible abitrageurs exploit mispricing of a convertible bond compared with the theoretical value of a plain vanilla bond and separate option.
Their appetite for fresh convertible issues is likely to wane if they cannot easily sell equities short.
“[Short selling restrictions] have perversely closed off another source of funding for corporates at a difficult time,” says Peter Douglas, head of GFIA, a hedge fund consultancy in Singapore.
He is hopeful regulators will review their restrictions on short selling in the next few months.
“In the long term, my best guess is we will end up with more disclosure, but there will be no substantive change to the rules.”
Many managers have said to him: “We have a counterparty problem. Markets are extremely difficult. The crisis is not a hedge fund crisis, it’s a banking problem. So why on earth are the regulators making life difficult for us. It’s not fair.”
But he is philosophical. “As my mother used to say, ‘Life’s not fair.’”
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