When speed is of the essence: working the short sell in Asia

Speed is critical when going short in Asia's emerging markets, says Lionhart's Jason Kennard. Success means knowing the market and your customers, and having 24-hour access to a trading platform that can adequately back up your strategies, he adds

According to a recent report from Lipper, inflows into short selling hedge funds hit record levels during the first quarter of 2007, reaching $215m. This means that short-biased hedge funds now manage $3.1bn in assets.

Despite increasing investor interest in the strategy, however, there is currently little understanding of how it works.

The shorting of a multi-asset book is a complicated business, and there are elements of the process that are key to ensuring success. The ability to move rapidly and effectively in the market will make or break a trade.

To speedily nip in and out of shorts is reliant on a number of elements: good relationships, knowledge of the market and sophisticated trading systems are all essential.

Taking convertible bonds as an example, the basis of shorting is to borrow the underlying equity, creating a hedge.

However, as bonds come on to the market, the availability of the corresponding equity is put under pressure from increasing demands to borrow. It is therefore essential to make sure you know who is likely to hold positions in the underlying equity and to be able to borrow from them before the market moves against you.

Traders need to be constantly on top of the market colour, watching as the price is pushed up (or down) to secure borrow, keeping the trade open. Alternatively, if the underlying stock isn't available, it is possible to hedge with a closely correlated instrument - either a comparable stock or a sector exchange traded fund (ETF) for example.

However, this is not to be used lightly, as this synthetic hedge may not provide the same level of protection. Generally speaking, if the trader is unable to secure a borrow on the underlying stock, they are unlikely to continue with the trade.

Increasingly, for larger trades, the convertible bond and the underlying equity are packaged together, which can result in a cheaper instrument than would be available separately in the market.

However, for smaller trades you still have to go to the market, and as such it is important to be on the ground in the market to ensure that no time is lost.

A solid relationship with prime brokers and stock-loan houses is crucial. They provide the background information on developments in the market and work with counterparties, matching those who wish to short with those who wish to have a long position on the instrument.

relationship management

Key to success in shorting is the relationship a hedge fund has with its counterparties. There needs to be a degree of trust between those involved in the trade.

The risk associated with such a trade is managed as a group, and as such, all need to be aware of corporate actions, corporate events, marketplace activity, and dividends as well as recall risk, which is the risk that the lender may ask for the stock back, especially when shorting on mergers and acquisitions (M&A).

A hedge fund that is successful in shorting will be aware of upcoming events on both the credit and debit sides of the businesses involved in the M&A activity, particularly as hedge funds don't wish to be exposed to the over-borrow associated with upcoming dividends.

In merger and acquisiton shorting, it is also essential to have a good understanding of who is a reliable holder of the shares.

In Asia in particular, the rate at which available instruments are accessible in the market is a matter of minutes. To short such equities, and hedge against the company acquiring, the individual needs to know exactly who to go to to obtain the equities before everyone else.

In addition it is necessary for responsible investors to actively engage with local regulators and industry bodies such as International Securities Lending Association and Pan Asian Securities Lending Association (both of which help to develop regulatory frameworks and ensure fair market practices) to ensure compliance.

This is even more pertinent in emerging markets, where stock lending and short selling have quite esoteric regulations around them.

For example, in Hong Kong there is a strict legal framework with a designated short-sell list. Participants in the market are only allowed to short on the shares highlighted in the list.

Similarly, traders are limited to shorting shares when they are on an up-tick and are restricted from selling on a down-tick.

Consequently, a solid understanding of the rules and regulations of each local market is a necessity. It is essential to have a solid comprehension of the individual nuances in each market as, taking Hong Kong as an example, a failure to do so may even result in a jail sentence.

Hedge funds simply would not survive if they failed to immerse themselves in the intricacies of the local regulation and, therefore, a solid relationship with local lawyers and regulators is a major element of any strategy.

Asia - the brave new world of shorting

The Asian market provides a lot of interest for many hedge funds that are looking to short. In Malaysia in 1996 short selling was widely used as an investment strategy.

However, with the economic crisis of 1997, this practice was suspended. It is only now that short selling is permissible again in the region, but at this point in time the only institution acting as a stock loan house is UBS.

Again, with the example of convertible bonds, the market is becoming more important, as when convertible bonds are faced with a wobble in the Hong Kong market, participants begin to look to Malaysia for trading opportunities.

Successful shorting is dependent upon being one step ahead of the market, and it is those trading emerging markets that offer maximum returns.

However, to make the most out of the investment, ideally hedge funds need to be ahead of the market's movements and to already be an established player when others join. In the BRIC countries, India and China present opportunities for shorting. However, in order to make the characteristic speedy short trades, hedge funds need to access the markets first.

It is currently suspected that China will be the next big arena, ahead of India, with rumours of Taiwan assisting in the preparation and set-up of a shorting market. However there are conflicting rumours of India allowing short selling as soon as the beginning of July 2007.

The Philippines has also recently announced plans to open its markets to short selling following setting up a stock borrow and loan market in February. The market rules are similar to the ones in Hong Kong, including an up-tick rule on the last sale price and some disclosure legislation.

In addition, a short selling order will only be allowed when it has been reasonably proved that arrangements for the ensured availability for delivery of the shorted security have been made.

To be a truly fast and nimble player, the hedge fund needs to have sophisticated software in place. Lionhart has developed SAFARI, which monitors and controls the short book, borrows, auto-reconciliations and so on. It also acts as a device to register the fee associated with each short. When a shorting position opens up, SAFARI takes on the responsibility of ensuring an accurate fee is charged.

Without having a refined system in place, it is easy to miss the optimum opportunities for shorting in the market. To truly be a contender in the shorting market, hedge funds need to have a global team monitoring and reacting to the market 24 hours a day.

Traders need to be on top of the market colour constantly, ensuring the price is pushed up to secure borrow, keeping the trade open. Speed drives success in shorting, particularly when shorting a global, multi-strategy book.

However, speed is not achievable without relationships and knowledge of the market, the ability to act at any time of day and a trading platform to back up strategies.

In the emerging markets there is much opportunity to make high returns, but this is only realistic for those with their finger on the pulse.