When I stumbled into the stock market 40+ years ago, the summit of equity portfolio manager skill and achievement was the long/short fund. Half the dollar value of holdings would be long positions, funded by an equal amount in stocks sold short. Therefore, in a-little-too-simplistic way of putting it, these funds had no net exposure to the general ups and down of markets; their performance was determined instead by the spread (+ or -) between the performance of the longs and that of the shorts. So , arguably, the fund could make money both in up and down markets.

As far as I’m aware, no one does this anymore. How so? I think it’s because, even though managing one of these funds sound hard, it’s actually much harder than that.

An example: the first portfolio I worked on as an analyst was a short portfolio. One of the first stocks I advocated shorting was Dr. Pepper, at that time a regional seller of soft drinks whose weak earnings suggested to me that it was in decline. What a disaster! The company was almost immediately taken over at a premium price, as part of what turned out to be the early days of a decades-long industry consolidation.

That taught me an essential difference between being long and being short. The mindset is completely different. On the long side, all you need is a few someone elses who think, like you, that a stock is undervalued. On the short side, there are a lot fewer professional portfolio managers. A big plus, meaning, I think, that this end of the market has less efficient pricing than the long side. However, the biggest negative, in my view, is that everyone–even owners of landfills–has to think the stock has no investment merit for the short to work out. So basically you need a Shohei Ohtani of finance, something that doesn’t come along very often.

The mechanics of shorting are simple:

–you borrow the stock from an owner, usually arranged through a broker, and very often from an institutional investor. Most big money managers have dedicated stock lending operations to do this,

–you sell the stock and get the use of the proceeds

–you pay the lender a recurring fee, that varies with the scarcity of the stock in question

–you agree to return the stock on request, meaning you have to go into the market to buy it.

the role of meme stocks

During the pandemic, traders with large online followings noted that for down-and-out stocks like Gamestop (GME) and AMC Theaters (AMC) essentially all the shares available for trading (the float) had already been borrowed and shorted. In fact, some had been shorted more than once, that is, more than all the float had been sold short. So if all those shares were called back by their owners, it would be impossible for all the people who had shorted them to comply. The stocks would go through the roof…and the shortsellers were apparently clueless. This is called a short squeeze. And GME was primed for one of epic proportions.

So Roaring Kitty and other traders lit the match. GME went from $5 to $120. Owners who had lent the stock called it back as they saw a unique chance to exit the stock at a gain. Shortsellers scrambled to buy back the stock and deliver it to the owners. On the day GME breached $120, trading volume was almost 10x the float.

Melvin Capital, the most prominent of the GME shortsellers, had to be bailed out by other hedge funds and essentially went out of business as a result of GME losses.

today’s situation

There’s some arcana involved in the calculation, but the short interest in GME was about a quarter of the float last week when Roaring Kitty tried again to trigger a short squeeze. That’s a lot, relative to the average exchange-traded stock, but still a whole lot less than back in 2020.

my thoughts

What I find the most weird about this is that in 2020 supposedly intelligent hedge fund managers either would not realize that their funds had ended up as all-or-nothing bets that these meme stocks would quietly die, or, equally bad in my view, that the risk/reward for holding them for the last dollar or two was acceptable.