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Hedge Funds Getting It in the Shorts

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Having bet against the wrong stocks, they're now behind the 8-ball.

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If you want to take the pulse of the market, just look around and see what's happening to short sellers.

A few months ago, you could go to mainstream websites and find tutorials on short selling. It was taken as a given that the market would keep falling, but thankfully there was an easy way to make money: Just go short.

Well, a few months into one of the most violent rallies -- short-covering or otherwise -- in market history, and we're seeing the carnage, particularly among those who shorted financials like Bank of America (BAC), Citigroup (C), and Wells Fargo (WFC).

Boston hedge fund manager George Noble announced the closing of his Gyrfalcon funds after losing 30% this year, presumably in some ill-timed shorts. Noble had an exceptional multi-year record and was prescient earlier this decade in front of the dot-com bust. A couple of bad months were enough to force this seasoned and proven manager to fold his tent.

It was recently announced that Cantillon, once a powerhouse fund run by top manager and academic William von Mueffling (formerly of Lazard (LAZ)), would be returning to its long-only origins. Von Mueffling was down about 10% last year -- thoroughly admirable returns, particularly for someone with a record of outperformance in up markets. But losing 7 or 8% this year, evidently from damage on the short side, apparently put him too far behind the 8-ball.

The next time we're in a steep downturn -- when short selling looks like easy money, and short sellers are being vilified --I hope the decision makers are reminded of what's happening to Gyrfalcon and Cantillon now.

These are the realities of the investment managers' double whammy -- redemptions because of short-term underperformance and high watermarks. The latter, which limit hedge funds' ability to generate fees after a stretch of losses, are a fact of life in the fast lane. But they have some dangerous pro-cyclical characteristics. When the market's down, they tend to force long-only managers to sell into abysses. In rising markets, they drive actively shorted stocks to unsustainable prices. Both cases provide undesirable outcomes for the average investor.

The answer lies in getting investors to reward longer-term performance. Incentives need to be changed to tie managers' compensation to this metric. It's often argued that good performance attracts assets, thus providing a natural incentive for managers to act in their investors' long-term interests.

But the truth is, there's very little tolerance for short-term pain at the individual level. This leads to performance-chasing and capital misallocation in the macro picture. We, as a society, suffer the results.
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No positions in stocks mentioned.

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