Handbook of Hedge Funds

8

Dedicated Short

He that sells what isn’t his’n, must buy it back or go to prison.

Attributed to Daniel Drew, a 19th-century speculator

In a sense, dedicated short hedge funds are traditional long-only funds flipped upside down. Their managers follow a radically different approach to investing – they look exclusively for overvalued companies, borrow their shares and sell them short. They then wait for the stock price to decline, so they can buy the shares back at a cheaper price, return them to the lender and pocket the difference. If, contrary to their expectations, the share price increases, the repurchase price will be higher than the initial selling price and they will make a loss.

Dedicated short sellers were once a robust category of hedge funds, but the bull market of the 1990s forced many of them out of business. Despite some revival in 2001 and 2002, hedge funds that exclusively focus on selling short are now rare. Many of them have migrated to the long/short equity space, where they operate with a net short bias. Most of the remaining ones are run by rugged individualists – unconventional men with a reputation for defying convention. They may be regarded as pessimists in an optimistic sort of way, anticipating profit from an imminent market decline that rarely transpires.

8.1 THE PROS AND CONS OF DEDICATED SHORT SELLING

There are several arguments suggesting that dedicated short selling can indeed be a very profitable activity. First of all, in sharp contrast to ...