Short-selling ban stuns hedge funds

Many lose a fortune and could fold up in the coming months

Published September 22, 2008

HEDGE fund short sellers, caught in Friday's bear squeeze, are believed to have lost fortunes. Many of them are expected to close down in coming months, analysts say.

Although a minority of hedge funds and traders made fortunes when Wall Street, London and other global markets soared, bears were caught unawares by the dual action of the US Securities and Exchange Commission (SEC) and the UK's Financial Services Authority (FSA). Both regulators, followed by Ireland and other European countries, clamped down on short selling.

Hedge funds, investment proprietary traders and other speculators had borrowed shares and sold them, aiming to profit from further price declines. Futures, options and other derivatives were also used to profit from a further market slide.

Instead, the short-selling ban caused an acute bear squeeze, forcing hedge funds and other bears to buy back shares.

Prices opened sharply higher as selling dried up and the bears scrambled to cover their short positions. Banks, insurance companies and other financial shares rose between 30 per cent and 60 per cent at one point, before falling back when the market began to settle down.

The bear squeeze and exceedingly volatile markets in recent weeks have now placed a question mark on the viability of some hedge fund businesses.

George Ball, chairman of Sanders Morris Harris Group, a large American asset manager, is predicting that 1,000 hedge funds will fail in the coming 12 months. This follows 350 failures in the first half of the year. The regulatory restrictions will crimp the flexibility of hedge fund managers, he says.

Hedge funds are likely to be under severe pressure for several reasons:

First, performance has been poor. In the year to Sept 18, before the huge rally on Friday, Hedge Fund Research's HFRX daily global hedge fund index was already down 9.7 per cent.

Relative value hedge fund strategies had fallen by 17 per cent while the HFRX long short hedge funds had declined by 11.6 per cent. Macro hedge funds, that trade all the markets, were still up by 4.6 per cent because of a good first half.

Second, withdrawals are accelerating and risk-averse investors have reportedly given hedge funds notice that they intend redeeming their investments by the end of the year.

Third, short-selling restrictions, tighter regulation and deleveraging are limiting hedge fund manager flexibility and trading.

Fourth, banks and prime brokers are expected to reduce loans to hedge funds. The borrowing and consequent leverage helped them profit in dull markets.

The regulatory moves to curb short selling received praise from companies and the expected criticism from AIMA, the hedge fund industry body. The regulators were accused of creating false markets in banking shares, but they countered that in the current crisis something had to be done to underpin faltering banks.

'The Commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets,' said SEC chairman Christopher Cox.

The SEC said it had banned short selling in 799 financial companies until Oct 2, while Britain's FSA has placed 33 companies on its banned list.

Ireland also outlawed short selling of its biggest banks but said the ban would be kept under 'continuous review'.

The Committee of European Securities Regulators warned further short-selling restrictions could be imposed across its 27 member states.


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