'Shorting and Haircutting' in Hedge Funds

One interesting paper from LBS. Strategies of Shorting in Hedge Fund is interesting. I think going short has more optionalities in hedge fund trading than going long and hedging it.


The Risk in Hedge Fund Strategies: Theory and Evidence from Long/Short Equity
Hedge Funds

The classic hedge fund – the fund founded by A. W. Jones in 1949 – was a long-short equity fund. It is still the major category of the hedge fund industry. Despite this, little is know about the sources of risk and return from such strategies. This paper sets out to study those risks and returns. This paper begins with an analysis of the micro-economics of shorting. It details four sources of return: the long position, which may be loaned out, generating an equity risk premium and stock lending fees; the short position, the risk free rate, and the net of the stock borrowing and stock lending fees, including any ‘haircuts’ imposed by other intermediaries such as prime brokers.
Returns from funds employing equity long/short strategies are modelled using the Fama-French factors of market risk, size, and value, augmented by a momentum factor. The analysis shows that hedge funds do show a statistically significant alpha, whereas hedge funds with a long bias, and equity mutual funds, do not. The most powerful explanatory variables are the market itself (such hedge funds tend to be net long) and the Fama-French size factor. The authors do not find that equity long/short returns are better explained by non-linear, option-writing, strategies. A variety of international equity indices, including emerging markets and economic sectors, also have no explanatory power.
Instead, the authors do find that high trading activity, and in particular a low level of short interest help to explain equity long/short hedge fund returns. They conclude that these funds benefit from volatile market conditions, when more arbitrage opportunities present themselves, and from superior access to stock borrowing opportunities, especially when other players are reluctant to borrow, for whatever reason.