Hedge funds have historically used short selling as a trading strategy, while mutual funds have generally not permitted the practice.  But, mutual funds are increasingly allowing their managers to engage in short selling as an investment strategy, growing from 23% in 1994 to 60% in 2006, though only 7% actually practiced shorting. Research by Accounting Professor Hemang Desai of SMU Cox, Honghui Chen, and Srinivasan Krishnamurthy reveals the first evidence that mutual fund managers who engage in short selling exhibit superior performance or skill.


Recognizing Alpha

A great number of studies have found that, on average, mutual fund managers do not beat passive benchmarks such as the S&P500 index. Thus, it is difficult to identify skilled mutual fund managers, ex-ante or in advance. However, that an average fund doesn't beat passive benchmarks does not mean that skilled managers don't exist; it's just hard to identify them.  Recent research has shown that fund managers who concentrate or weight more heavily in one sector or industry show superior performance. The evidence in this paper suggests that short selling by mutual funds is a reliable indicator of managerial skill.  Various restrictions on short selling (margin requirements, not having access to proceeds from short selling immediately, etc) make short selling a costly activity. Thus, theory suggests that such restrictions will disproportionately drive out uninformed investors. Therefore, on average, short sellers are likely to be informed investors.  The evidence in the paper is consistent with this prediction.

Of the study's 323 mutual funds that took short positions in U.S. stocks, average net assets were $678 million; they were younger funds with higher management fees, larger expense ratio, and greater portfolio turnover compared to control funds. Of the 2,066 mutual funds which allowed shorting, 323 funds chose shorting as part of their array of trading strategies. These managers outperformed similarly matched funds in the control group by 2.0 - 2.3%. This positive alpha is indicative of their stock picking skill.  The study examined both the long and short positions of these mutual funds and found that the managers are able to generate a statistically significant alpha on their long and short positions.  To further corroborate evidence of skill, the authors also examined the performance of other funds managed by the same managers where short selling was not permitted. The results show that these managers generate an alpha of about 1.7 to 2.6% per year in those funds.


Short sellers, the forensic accountants

A second debate surrounding this research is about the practice of short selling itself.
In this highly reactive regulatory climate in which scapegoats are sought, the very practice that distinguishes these managers, short selling, may be getting the short end of the stick. Prior research by Desai shows that short sellers are sophisticated investors. For example, an examination of short selling activity in firms that later acknowledged material accounting errors shows that short sellers target these firms months in advance of their eventual acknowledgement of accounting errors. "Short sellers serve as an advance warning system to regulators," Desai says. "They point out companies that are doing questionable things with their books or stocks that are grossly overpriced." Thus it is not clear that the perceptions about short sellers-that they unfairly target companies-is borne out in the data.

A lack of short selling restrictions did not cause or contribute to the financial crisis according to Desai. He acknowledges that any abusive practices should be curtailed. Changing short selling restrictions, as the Securities and Exchange Commission is currently debating, will have little effect, Desai believes. "More importantly, if these restrictions are designed to reduce short selling, there could be adverse consequences," he adds. "Short selling plays an important role in giving advance warning of corporate malpractice or outright fraud. If we restrict short selling, prices will become less informative."

Desai says overpricing is not necessarily a good thing. Consider a stock price trading at $50, when it should be $25; this causes a firm's manager to overinvest as the firm tries to justify the market's growth expectations. "If you have an active market that allows the bears to express their viewpoint, maybe the stock won't get to $50," Desai relays.

If regulators clamp down on short selling, skilled fund managers and investors will be constrained. It increases the likelihood of mis-pricing according to Desai. "Bears play an important function," Desai states. "We don't want only the optimists to set the price. You have to provide the incentives for people to look into the company and question if things are not what they seem. " If there are increased impediments to short selling then they may not have incentives to examine questionable practices by firms and this can also be costly to the society, Desai notes.


"Identifying skilled managers: Evidence from mutual fund short sales" by Hemang Desai of SMU Cox, Honghui Chen of University of Central Florida, and Srinivasan Krishnamurthy of SUNY-Binghamton University is under review.

Previous research about short sellers can be viewed at:
http://www.cox.smu.edu/article/research/research.do/155

Written by Jennifer Warren.