August 2007

SECURITIES RESEARCH: Got any bright ideas?

Few brokers are willing to make sell recommendations, but with the onset of 130/30 funds, more managers are finding ways to research the market. By Angelique Ruzicka

07_08_securities_researchAt what some call the peak of the bull run it’s particularly hard finding the right stocks to short. Last month, Cartesian Capital brought this to light by slamming hedge fund managers for running closet long-only portfolios. Andrew Kelly, co-manager of the Cartesian UK equity long/short fund pointed out how the end of June last year provided a clear insight into this long-only bias, when many UK hedge funds fell

4-5%, closely mirroring the performance of the mid-cap index. “The recent downturn clearly showed that many hedge fund mangers are simply running closet long-only portfolios. They usually do well when the market performs well – but what happens when the index falls? As it stands, they are only making money from longs,” says Kerry.

Hedge fund managers are not going to be the only ones scratching their heads over where to get the next best shorting ideas from. With 130/30 funds gaining in momentum in Europe as a result of pan-European financial institutions such as Pioneer, Scottish Widows Investment Partnership (SWIP) and F&C launching these products, more traditional managers are going to be scouring the market for short ideas. Shorting ideas can come from two sources: managers could either use their own in-house experts, or gain ideas through third parties such as brokers and independent research providers.

Generally, those already in the game of hedge and 130/30 funds turn to their in-house experts for ideas on shorting. “We have our own in-house analysts and they know the drivers of why they don’t like a stock and I leave them free to pick their own pairs. But they do have to say why they are going long and short, particularly when it comes to the short,” says Neil Dwane, CIO Europe at RCM.

Meanwhile, Pioneer has enhanced its own proprietary quant model to accommodate the 130/30 fund that it is launching in September/October of this year. “The way we are doing shorting is purely via a quantitative approach that is leveraged off our research capabilities at Pioneer. We have used our quant model for a while but we’ve just never used the shorting capability. That’s the beauty of implementing 130/30, it enhances what you already have,” says Griff Williams, institutional product specialist at Pioneer Investments.

The long and short of it
There is no overall consensus on whether the fundamental or quant approach is the best way when it comes to researching short sell ideas but Griff feels the quantitative approach is the way forward for those going into 130/30 funds. “Our back testing tells us it’s successful. We end up with 150 positions, 75 of which are long and 75 short and because of that diversification we won’t be hit by any big surprises. Shorting can get dangerous and you can get into trouble, particularly when you adopt the fundamental approach. You need to be objective instead of picking from your favourite sectors and stocks.”

If you don’t have the in-house expertise sell-side brokers can be your first port of call. There are various ways in which you can get information from brokers but very few have trodden the path that Fidelity took when it declared that it found research so important it would pay a $7m (e5m) yearly payment to Lehman for its research expertise. “It was shocking to see package payment for research. Fidelity came out and set a price on what had heretofore been a very opaque process,” says Gunnar Millar, head of European research and co-head of global research at RCM. But Millar doubts whether any financial institution will adopt the same approach as Fidelity. “It has not been repeated as not everyone is a Fidelity that has extra cash in their pocket. This move is at odds with the bundled world and you still have to pay via mark-ups these days,” he adds.

But the problem here is that there aren’t many brokers that are comfortable with recommending a stock as a ‘sell’. This is mostly for fear of rubbing clients up the wrong way. “There isn’t a lot of it [sell ideas] around as banks have a lot of touch points with the securities and are conflicted in so many ways that they’d be hesitant to give sell ideas,” says Dwane.

However, one fund management company has found a way around brokers’ hesitancy. Henderson Global Investors found that getting the best out of brokers means providing some incentive and a competitive environment. The group deals with between 10-15 sell-side brokers. “We ask sell-side brokers to come up with long and short ideas. They run a long and short portfolio through our Alpha Network and have to come up with five stocks they would go long on and five they would go short on and we incentivise them on the performance of that portfolio. We reward our brokers through commission and there is a lot that goes into calculating it, and one of those things is performance,” says Alistair Sayer, investment director for multi strategy equity at Henderson Global Investors, which manages around $2bn (e1.45bn) in short extension funds.

Competitive spirit
Henderson creates the competitive environment by allowing brokers to see how they compare with their peers. “On the Alpha Network system they are all anonymous and they can see how their competition is doing and this fosters the competitive spirit. Alpha Network acts as a collective of information, where we can see where brokers have gone long and short. And if we want to find out why they have done so we can pick up the phone and ask them,” adds Sayer.

With the growing number of managers interested in 130/30 products credit ratings agencies, such as Standard & Poor’s (S&P), are also providing the industry with more advice on shorting stocks. S&P has a five-tier system whereby they rate stocks by giving them one star (which indicates strong sell) and five star (which indicates a strong buy). It distributes its research through wholesale clients such as Fortis and Nordea and also licences recommendations to third parties. “Typically we focus on buy recommendations, but with more hedge funds in the market there is increasing interest in our sell recommendations,” says Subhajit Gupta, director of research, Europe at S&P.

Like most analysts and brokers S&P’s portfolio of sell recommendations is still outweighed by the number of buy recommendations it makes. Gupta is very candid as to why the industry has a sell bias. “It’s not that analysts have rose tinted glasses, clients don’t like you issuing sell recommendations as they may have that share in their portfolio. With sell recommendations you antagonise more people than you please. You get more kudos on recommending buys than sells.”

Gupta reckons that S&P goes beyond the industry norm when it comes to sell recommendations. “Our sell recommendations consist of around 26% of our portfolio and that’s very high. It’s our deliberate attempt to have a balanced portfolio of buy and sell. If you look around the industry most have sell recommendations of less than 20% in their portfolio,” says Gupta.

Of course, it’s no secret that managers can lose a lot of money making the wrong judgements on shorting stocks. Michael Berger, who started the Manhattan Investment Fund in New York, is perhaps one of the more spectacular examples of how getting it wrong in shorting can prove disastrous. He started his hedge fund in 1995 and collected over $575m (e419m) in 1999. But after his arrest in Austria last month, Berger admitted to hiding losses of around $400m (e291m) after making wrong bets when shorting on internet stocks.

Even analysts and managers admit to getting it wrong from time to time. While some sell recommendations may look good at the time, things can change drastically. “We recently had a sell recommendation on Danone as we thought it had issues with its cookies business, but then management sold the business and its shares went up. Our sell recommendations over the long term have underperformed, but it involves a lot of companies that have been bid for by private equity companies. However, over the last year our sell recommendations have outperformed our buy recommendations,” says Gupta.

“Shorting is a different skill set,” adds Dwane of RCM. “For our hedge fund in the first year our long ideas were good but our shorting ideas were awful, in the second year we got better and in the third we got it right. It’s a learning experience that you have to get through.”

Help is at hand
It’s certainly not easy finding short ideas in the current environment but industry commentators expect more help to be at hand as the rage for 130/30 funds spreads across Europe. Some help has already arrived on the scene. “If you are a place that doesn’t have in-house expertise or if you find that brokers don’t give enough ideas, there is a wave of third-party research providers coming onto the scene, such as Arete and forensic accounting research firms like CFRA,” says Millar.

The analytical industry is changing, albeit slowly, to cater more to hedge funds and managers entering the 130/30 fund space and no doubt more research houses will spring up to provide sell recommendations. It’s not clear whether any will specialise purely in short selling ideas, but certainly those who get it right and set themselves apart will be highly regarded. “Many independent research houses are still offsprings of banks and still recommend buy ideas. Once more firms go into 130/30 more long-short research firms could spring up. There will be another Enron soon enough and those who can spot that would be very valued,” adds Dwane.

© fe August 2007