Re: 5/22/03 - David A. Rocker: The Long and Short of Hedge Funds: Effects of Strategies for Managing Market Risk
DAVID A. ROCKER
Managing General Partner, Rocker Partners, L.P.
Presentation to the House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises “The Long and Short of Hedge Funds: Effects of Strategies for Managing Market Risk”
May 22, 2003
My name is David Rocker [1] and I am the managing general partner of Rocker Partners, L.P., a New Jersey based hedge fund. I am honored to have this opportunity to address the House Subcommittee on Capital Markets to offer my views on hedge funds, short selling and the appropriateness of possible additional regulation.
Rocker Partners is an eighteen year old firm with a contrarian style. While we maintain both long and short positions, we have focused our research efforts more heavily in recent years on short selling because we have identified more stocks which we have felt were overvalued than those which we felt were attractive. We are generally viewed as a specialized manager and our investors, primarily wealthy families and institutions such as universities, hospitals and endowments, often use us as a risk-reducing hedge against their long biased investments.
Hedge funds have grown rapidly because they have served both of their constituencies, investors and managers, better than more conventional alternatives. Over the last six years, which encompassed both the expansion of the equity bubble and its subsequent deflation, an investment in an average- performing mutual fund would have remained essentially unchanged, but the same investment in an average performing hedge fund would have appreciated approximately 75%, and would have done so with lower volatility. Investors have also been attracted to hedge funds because of the greater identity of interests between the fund manager and the investor. Substantial personal assets of hedge fund managers and their families are typically co-invested alongside limited partners, and such investments typically represent a much higher percentage of the total assets under management than is the case in mutual funds. Hedge funds frequently provide a more attractive financial opportunity for successful managers. The broader investment flexibility available in a hedge fund structure has also proven appealing. Many former mutual fund managers have joined or started hedge funds in recent years.
While there is considerable discussion as to whether hedge funds require greater regulation, it is important to recognize that even unregulated funds are already subject to a substantial degree of oversight by their investors. Fund investors, especially in mature funds such as ours, impose tremendous demands on managers with whom they choose to invest, including, among many other things, that the fund has formal compliance policies, appropriate restrictions on employee trading, some amount of investment transparency, specific risk management techniques, operational proficiency, and a whole host of other protective requirements. The hundreds of billions of dollars invested in the hedge fund marketplace require, as a matter of fund Darwinism, best practices to be employed by hedge funds, and those managers that do not or can not provide these protections to the investor marketplace generally do not succeed or survive. Additionally, the co-investment of the hedge fund manager’s personal and family assets helps serve as a self-governing mechanism.
The highly publicized hedge fund blow-ups in recent years must be placed in perspective. Such funds have represented fewer than ¼ of 1% of the industry and the superior investment results cited earlier include the losses from these entities. As the present structure has served investors well during both rising and falling markets, I believe additional regulation is neither necessary nor desirable. Existing regulations, effectively applied, coupled with the extensive due diligence and operational requirements of large investors, have proven sufficient to date. Anyone willing to commit fraud will not be deterred from doing so by a registration requirement. With few notable exceptions, hedge funds have proven less risky than conventional alternatives, so the present focus on them is somewhat puzzling.
The issue of retailization raised by Commissioner Donaldson, among others, merits careful consideration. On one hand, most present investors in hedge funds are large and sophisticated and have the capacity to analyze and endure the risk of investing in these funds, whereas the smaller public investor is less well-equipped to do so. On the other hand, one must question why the apparent advantages of hedge funds cited above should be denied the retail investor. As most of the blow-ups in hedge funds have come from the excessive use of leverage, it may be prudent to preclude retail investors from investing in highly leveraged funds.
I would now like to turn my attention to short selling and the important role I believe it plays in creating more liquid, balanced and fair markets. Short sellers already operate on a playing field tilted sharply against them, and considerable restrictions and risks relate specifically, and often uniquely, to this strategy. Unlike a long investor who can buy a stock at any price or repeatedly at ever higher prices intraday, the short seller must initiate his or her position only on an “uptick” – a price above the immediately preceding trading price. In contrast to a long position, in which only the initial investment can be lost, there is a risk of potentially unlimited loss on a short position. The short seller is obligated to pay dividends to the holder from whom stock was borrowed and, most especially, there is the potential loss of one’s ability to determine when the short position is purchased or covered. If the supply of borrowable stock dries up, the short seller may be involuntarily “bought in” by his broker in what is generally known as a “short squeeze.” The short seller has no control over when the stock is bought in or the price at which it is executed. This situation is clearly distinct from that of the long holder who cannot be forced into an involuntary sale.
The contribution of the short seller to more efficient markets can be best evaluated in the context of the stock market of the last six years. An equity bubble of extraordinary proportions developed in the late 1990’s peaking in early 2000. The internet mania was just the most visible part of the general hysteria. Since the peak, the bubble has deflated, costing investors some $7 trillion dollars.
The goal of regulatory policy must be to establish fair and safe markets for investors. In considering what, if any, regulatory changes are appropriate, I believe it important to reflect on the forces that created the bubble as well as those which have led to its demise. In that connection, it is important to understand the structural bullish bias in the market. Shareholders, of course, want their stocks rising. Corporate officers desire higher prices, as the price of their stock serves both as their report card and, thanks to the liberal use of options, the key to enormous personal wealth. Higher stock prices also provide inexpensive acquisition currency for acquisitive issuers. Security analysts clearly want stocks higher to validate their recommendations. There must be a seller for every buyer or no trades would occur. Thus, it is interesting to note that while 50% of stock transactions are, by definition, sales, purchase recommendations by analysts are 10-20 times more numerous than sale recommendations. The recent Wall Street settlement has focused on the pressure placed on analysts from internal investment banking, but pressures from clients and corporate executives have received much less attention. Analysts who recommend the sale of a stock risk the ire of their clients who own it. These clients complain to research directors and can withhold favorable votes in reviews important to analysts’ compensation. Similarly, corporate executives frequently react in a hostile manner toward any analyst who downgrades their stock, restricting his or her contact within the company, thereby making future analysis of the company more difficult. Collectively, these factors, coupled with a cheerleading media, created the bubble. Anyone challenging the valuation of a company or the integrity of its financial statements was most unwelcome in this environment. Analysts and market strategists who either warned of overvaluation or were insufficiently bullish were pushed aside, replaced by those who went along with the irrational exuberance.
Short sellers, through their research and public skepticism, provide a much needed counterpoint to the bullish bias described above. They are willing to ask tough questions of managements in meetings and on conference calls, thereby providing a more balanced view for listeners. Investors benefit by getting both sides of the story when the views of short sellers appear in the media. [2]
Short sellers have helped uncover many frauds and accounting abuses in recent years at Enron, TYCO, Conseco, AOL, Boston Chicken, Network Associates and Lernout & Hauspie, among a host of others. Short sellers frequently serve as unpaid, but self interested, detectives and have willingly shared their findings with the SEC, which has acknowledged the usefulness of these inputs. Although there have been occasional instances in which short sellers have been accused of circulating misleading stories, these instances are dwarfed both in number and magnitude by the misleading stories circulated by long holders and the issuers themselves. Because of the greater risks in short selling, research done by short sellers has tended to be more careful and accurate than most. As Gretchen Morgenson of The New York Times recently reported:
If you own shares in a company that declares war on short sellers, there is only one thing to do: sell your stake. That’s the message in a new study by Owen A. Lamont, associate professor of finance at the University of Chicago’s graduate school of business… The study, which covers 1977 to 2002, shows not only that the stocks of companies who try to thwart short sellers are generally overpriced, but also that short sellers are often dead right. [3]
The value of short selling as a means for creating greater liquidity and orderly markets is well understood. Specialists on the major exchanges sell short to help offset an imbalance of buy orders. Trading desks at brokerage firms do so as well to facilitate customer orders. It is important to note that over two-thirds of short selling is related to arbitrage activity.
Any effort to further restrict short selling should be rejected. While short sellers seem to attract a disproportionate amount of attention, usually from companies with questionable accounting or business models who do not welcome scrutiny, the number of short biased firms are few in number and are actually shrinking. Many short sellers were driven out of business during the bubble and, even today, they represent the only subcategory of hedge funds that has seen net redemptions in recent years. Of nearly 6,000 hedge funds, short biased funds with asset bases of $100 million or more number fewer than 10, and the total assets managed by these entities are well under 1% of the total assets managed by all hedge funds. That few managers have chosen this strategy or have been able to survive suggests that there are easier ways to make a living.
The short interest in each stock is reported monthly, yet there are proposals circulating, most visibly from the Full Disclosure Coalition now in formation by the Washington law firm, Patton Boggs, which would seek to have individual short sellers detail their short positions in periodic Schedule 13D and Form 13F filings. The claim being made is that this would level the playing field, but as shown earlier, the playing field is already tilted sharply against the short sellers. Such disclosure requirements would serve only to make targets of individual short sellers and likely drive them out of business. Some publications are designed specifically for the purpose of creating short squeezes which can be exploited by other aggressive hedge funds and mutual funds who know that short sellers cannot defend themselves by selling on down ticks. [4] Most companies simply ignore short sellers, recognizing that there are differences of opinion in free markets, and go about their business. In light of Mr. Lamont’s findings, it will be interesting to see which companies will become part of this coalition.
The Williams Act requires the filing of a Schedule 13D or Schedule 13G to alert a company that someone is accumulating more than 5% of their shares. No such threat exists from a short position. A short sale does not make the short seller the owner of the security (in fact, it is the opposite) and does not result in any voting authority for the short seller.
Given the positive contribution by short sellers and the evident shrinkage in their number, consideration should be given to truly leveling the playing field by modifying the uptick rule. This would contribute to greater market stability in today’s electronically driven securities markets.
Short selling is an important part of the public capital markets. Any further bias in favor of long investors will further erode the important counterweight short sellers provide to the market. Short selling is an important investment tool as part of a proper risk-reduction investment strategy. The marketplace not only understands the benefits of short selling; it in fact requires it.
Thank you for your time and attention.
[1] Prior to founding Rocker Partners, L.P. in 1985, I was a general partner of Century Capital Associates, a registered investment adviser I joined in 1981. Prior to that, I was a general partner of Steinhardt, Fine, Berkowitz & Co., a hedge fund I joined in 1972. From 1969 to 1972, I was a research analyst and investment banker with Mitchell Hutchins, Inc., a registered broker-dealer. I was graduated from Harvard College magna cum laude in 1965 and received an M.B.A. with distinction from Harvard Business School in 1969.
[2] I wrote articles for Barron’s “Other Voices” column during the bubble. The first in 1999, “A Crowded Trade,” warned of the dangers following the large mutual funds’ loading up on richly priced, large capitalization stocks. In 2000, “The Fed Should Act Now” urged the Fed to adopt more stringent margin policy in a clearly overheated market; and in 2001 I wrote “Fantasy Accounting” which identified how the failure to treat options as expenses led to a vast overstatement of corporate earnings. (Copies are included.)
[3] “If Short Sellers Take Heat, Maybe It’s Time to Bail Out,” Gretchen Morgenson, The New York Times, January 26, 2003.
[4] The ShortBuster Club formed by Sky Capital LLC™ and the Erlanger Squeeze Play. Examples attached.
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