Selling Depreciating Assets in a Hedge Fund
Hedge funds can make money by selling securities, and not necessarily securities that they own. A short-seller borrows a security from someone else (usually from a brokerage firm’s inventory) and then sells it.
After a while — ideally, after the security goes down in price (or depreciates) — the short-seller buys back the security in the market and repays the loan with the asset that he originally borrowed. The lender doesn’t have to repay the original dollar value, just the security in question. The profit (or loss) is the difference between where the short-seller sold the security and where he bought it back, less commissions and interest charged by the lender.
Short-selling reduces risk. By selling off part of the risk, the fund can make money while hedging the long position. For example, if a fund’s quantitative research finds that a given investment is heavily exposed to the price of oil, the fund can get rid of that risk by shorting oil futures. The fund offsets any gain or loss in the investment’s price caused by sensitivity to oil with the gain or loss of the futures position.
An investment short is a short-sell taken in a legitimate business that the fund doesn’t expect to do well. A fund may make the decision to go with an investment short as part of a matching long position in a competitor that it expects to do well, as part of a risk-management maneuver, or purely for investment success.
A fraud short is an investment that the fund expects to go down in value because of suspicions that the company is guilty of misrepresenting its products, its financial results, or its management. These investments are rare, but funds make a few of them every year.
A fraud short is risky stuff — the management of a company that a fund heavily shorts will probably fight back, sometimes with ugly tactics, and short-sellers who are anxious to get the news flow moving in their favor have been known to resort to lies and threats.
A fund exacts a naked short when it sells a security that it hasn’t borrowed in hopes that it will go down fast enough that the fund can buy back the security and settle with the buyer. Naked shorting is against exchange regulations in most markets, but it still happens.
The advantage for the fund is that it can sell short without paying interest to the lender, and it can sell short even if no lender will loan the fund the security. The downside is that if the fund can’t repurchase the security in time to settle its sale, the exchanges will find out and probably shut down the fund.