ANALYSIS-Perma bears to emerge from market hibernation

Published: 30 May 2009 17:01:21 PST

LONDON, May 27 - Bear funds should play a key role in diversifying portfolios in the long term once markets normalise, even as "green shoots" bulls force them to tweak their tactical strategies to ride out the current rally.

Bear funds -- estimated to be worth $5-10 billion -- borrow weak company stocks to sell and buy back at a lower price. The practice was temporarily banned by many authorities, mainly for banking stocks, after the collapse of Lehman Brothers.

While critics blamed short-sellers for exacerbating the market slide during the height of the crisis, such funds can play a return-enhancing role in a normal market, enabling long-term investors to minimise risks and volatility by adding short exposure to an otherwise long-only portfolio.

After posting double-digit returns in 2008, many short funds are in the red this year as world stocks <.MIWD00000PUS> rallied as much as 40 percent at one point.

This squeeze after months of a falling market caused virtually every stock to rally, including the weak company stocks that short funds target.

BlackRock says the 40-percent rally in U.S. stocks since March was dominated by lower-quality investments, with the highest-quality decile up barely 20 percent and the lowest-quality decile up 150 percent.

Charlie Morris, head of absolute returns at HSBC Global Asset Management, says normalisation in the marketplace -- where good stocks rise and bad stocks fall -- would benefit short funds, even if markets trend higher.

"Bear rallies are destructive in the short term... Bad stocks have rallied sharply. But the rally looks pretty tired now. Good short funds would reduce their risk tactically but not their strategy long-term," Morris said.

"They have positions on bad companies. They can be a good source of diversification because most investors have portfolios invested in good companies. By putting in a dedicated short seller, you are deconstructing hedge funds."

Experts say dedicated short bias funds must manage their risks more closely than long-only funds as their upside is limited -- performance reaches its maximum when stocks go to zero -- while the downside, brought by a stock price going higher -- can be infinite.

"(Short funds) take a significant role especially in economic uncertainty. You can almost create a synthetic hedge fund by investing in your favourite longs and adding short exposure," said David Tice, a 20-year veteran short seller who manages Federated Investors' <FII.N> $1 billion short fund.

GREAT DIVERSIFIER

According to Credit Suisse-Tremont, funds with dedicated short bias posted a loss of 8.5 percent so far this year, the worst performer among its family of hedge fund indexes. Thomson Reuters' Lipper U.S. dedicated short bias funds index fell more than 30 percent since hitting a record high in November.

However, short funds have the best one-year return of 3.22 percent, followed by managed futures -- which follow trends on a long-term basis -- which returned 2.9 percent in the past year, according to Credit Suisse-Tremont.

Its benchmark hedge fund index rose 2.5 percent since the start of the year while it lost 15.8 percent in the past year.

"It's not appropriate for many people but for someone who wants additional short exposure and has long positions, it is an interesting vehicle," said Kent Holden, managing partner of Holden Asset Management who runs a $200 million short fund.

"There are many long-short funds. Most of them don't have great expertise on the short side. Many of them are great long pickers. A client will hire us to give additional exposure on the short side and hire someone else to augment the long side."

The Greenwich, Connecticut-based fund is long-term short equity fund with an average holding period of 9 months. The fund turned 33 percent in 2008, while it is down 12 percent so far.

"We do fundamental research to find companies that are weaker than peers. There are always stocks that go down even in a bull market," Holden said.

"Traditionally in a bull market we've done quite well because there are companies that are coming out with new products, putting pressure on losers in the industry."

The Prudent Bear fund, which Federated's Tice manages, returned 27 percent in 2008 and is down slightly this year. He likes big-cap stocks to stay liquid. The mostly-short fund has long exposure to metal stocks.

"We're very diversified. We don't really invest in frauds, spasms, failures, or look for smaller cap names. We've adjusted our portfolio to be lower beta so we're more in consumer staples now to reduce the risk of losses during this rally," Tice said.

In each of the years from 2005-2007, when stocks rallied, the fund posted a positive performance.

Furthermore, any signs that the rally might be getting exhausted will set the stage for short funds to outperform.

The survey by financial services technology provider 1st-The Exchange showed earlier this month that 75 percent of 254 independent financial advisors thought the recent stock market gains were no more than a bear market rally.

More than one-in-three thought a bull run in equities was unlikely until Spring 2010.

"I've never more been convinced than anything in my life that this is a suckers rally," Tice said. "This is a short-term rally that is going to end in tears. In a secular bear market, there are always bear market rallies."

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