In this article, Youssef LOURAOUI (Bayes Business School, MSc. Energy, Trade & Finance, 2021-2022) presents the dedicated short bias strategy, which is a special case of the long/short equity strategy without the long component. The strategy holds a net short position, which implies more shorts (selling) than long (buying) positions. The objective of the dedicated bias strategy is to profit from shorting overvalued equities.
This article is structured as follow: we introduce the dedicated short bias strategy. Then, we present a practical case study to grasp the overall methodology of this strategy. We conclude with a presentation of the risk associated with this hedge fund strategy.
According to Credit Suisse, a dedicated short bias strategy can be defined as follows: “Dedicated Short Bias funds take more short positions than long positions and earn returns by maintaining net short exposure in long and short equities. Detailed individual company research typically forms the core alpha generation driver of dedicated short bias managers, and a focus on companies with weak cash flow generation is common. To affect the short sale, the manager borrows the stock from a counter-party and sells it in the market. Short positions are sometimes implemented by selling forward. Risk management consists of offsetting long positions and stop-loss strategies”.
This strategy makes money by short selling overvalued equities. The strategy can potentially generate returns in falling markets but would underperform in rising equity market. The interesting characteristic of this strategy is that it can potentially offer to investors the added diversification by being non correlated with equity market returns.
Example of the dedicated short bias strategy
Jim Chanos (Kynikos Associates) short selling trade: Enron
In 2000, Enron dominated the raw material and energy industries. Kenneth Lay and Jeffrey Skilling were the two leaders of the group that disguised the company’s financial accounts for years. Enron’s directors, for instance, hid interminable debts in subsidiaries in order to create the appearance of a healthy parent company whose obligations were extremely limited because they were buried in the subsidiary accounts. Enron filed for bankruptcy on December 2, 2001, sparking a big scandal, pulling down the pension funds intended for the retirement of its employees, who were all laid off simultaneously. Arthur Andersen, Enron’s auditor, failed to detect the scandal, and the scandal ultimately led to the dissolution of one of the five largest accounting firms in the world. Figure 1 represents the share price of Enron across time.
Figure 1. Performance Enron across time.
Source: (Data: BBC)
Fortune magazine awarded Enron Corporation “America’s Most Innovative Company” annually from 1996 to 2000. Enron Corporation was a supposedly extremely profitable energy and commodities company. At the beginning of 2001, Enron had around 20,000 employees and a market valuation of $60 billion, approximately 70 times its earnings. Short seller James Chanos gained notoriety for identifying Enron’s problems early on. This trade was dubbed “the market call of the decade, if not the past fifty years” (Pederssen, 2015).
Risk of the dedicated short bias strategy
The most significant risk that can make this strategy loose money is a short squeeze. A short seller can borrow shares through a margin account if they believe a stock is overvalued and its price is expected to decline. The short seller will then sell the stock and deposit the money into his margin account as collateral. The seller will eventually have to repurchase the shares. If the price of the stock has decreased, the short seller gains money owing to the difference between the price of the stock sold on margin and the price of the stock paid later at the reduced price. Nonetheless, if the price rises, the buyback price may rise the initial sale price, and the short seller will be forced to sell the security quickly to avoid incurring even higher losses.
Gamestop shot squeeze
GameStop is best known as a video game retailer, with over 3,000 stores still in operation in the United States. However, as technology in the video game business advances, physical shops faced substantial problems. Microsoft and Sony have both adopted digital game downloads directly from their own web shops for their Xbox and Playstation systems.
While GameStop continues to offer video games, the company has made steps to diversify into new markets. Toys and collectibles, gadgets, apparel, and even new and refurbished mobile phones are included.
Borrowing shares at the current market price, selling them, and then repurchasing them at a lower price is what shorting a company entails. If the stock price declines, the short seller will earn from the difference in price between when they sold the shares and when they repurchased them. In this scenario, roughly 140% of GameStop’s shares were sold short in January 2021. In this case, investors have two choices: keep the short position or cover it. Covering a short position includes purchasing the shares at a loss since the stock price is higher than what was sold. And when 140% of a stock’s float is sold short while demand is high, a large number of positions are closed.
As a result, short sellers were constantly buying shares to cover their bets. When there is this much purchasing pressure, the stock mechanically continued to rise. From the levels reached in early 2020 to the levels reached in mid-2021, the stock price climbed by a factor of a nearly a hundred times (Figure 2).
Figure 2. Performance of Gamestop stock price.
Source: (Data: Tradingview)
Unfortunately, the people on the other side of the trade lost huge amount of money. The hedge fund Melvin Capital lost billions of dollars after being on the wrong side of the GameStop short-squeeze. This, along with a few other poor trades, urged an emergency funding from Steve Cohen’s Point72 and Ken Griffin’s Citadel, both well respected hedge funds in the industry.
As Melvin Capital’s underperformance has persisted, the two billionaire investors have since reduced their holdings in Melvin Capital. The fund was down 21% at the end of the first quarter of 2022. This comes after a 39% decline in 2021. In the hedge fund industry, investors typically do not pay a performance fee for bad performance. If a hedge fund loses 10% for its investors in a given year, the investor would not be obligated to pay performance fees until the fund returns to breakeven. In the instance of Melvin Capital, the hedge fund would have required to achieve a performance gain of more than 100% to reach breakeven before it could begin to receive performance fees.
Why should I be interested in this post?
Understanding the profits and risks of such a strategy might assist investors in incorporating this hedge fund strategy into their portfolio allocation.
Related posts on the SimTrade blog
▶ Akshit GUPTA Short selling
▶ Youssef LOURAOUI Introduction to Hedge Funds
▶ Youssef LOURAOUI Global macro strategy
▶ Youssef LOURAOUI Long/short equity strategy
▶ Youssef LOURAOUI Portfolio
Pedersen, L. H., 2015. Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined. Princeton University Press.
Credit Suisse Hedge fund strategy
Credit Suisse Hedge fund performance
Wikipedia Gamestop short squeeze
TradingView, 2023 Gamestop stock price historical chart
About the author
The article was written in January 2023 by Youssef LOURAOUI (Bayes Business School, MSc. Energy, Trade & Finance, 2021-2022).