Horseman Global Unveils New Shorting Philosophy Using ETF Flows As A Catalyst

I am not a particularly big fan of the idea that markets are efficient. In fact I think people who believe this have never spent any time working in investment management. Everyone in the industry has seen how investment fads wash over the industry from time to time, only to wash out again as returns begin to disappoint.

    - Russell Clark, CIO of Horseman Global


Well, the redemption-driven capitulation is over, and what until recently was the world's most bearish hedge fund (which was down 24% in 2016 and another 7% to start 2017), with a net exposure in the negative triple digits is now effectively neutral, as the following breakdown of Horseman Global's latest portfolio demonstrates.

Indeed, with a net exposure of only -16%, the highest since 2011, his book must feel like a raging bull for Horseman and its CIO, Russell Clark.

And yet, not matter what, Horseman's desire to remain bearish, or perhaps contrarian, persists as his latest monthly note to investors reveals. In it, Clark not only provides an update on the fund's March P&L (down another 1.1% for a YTD of -7.7%), and breaks down the fund geographic distribution...

.... and top holdings...

.... but reveals a fascinating framework for how to approach shorting in a "new normal" world in which passive "investors" do the bulk of the capital allocation decisions.

But first, recall that earlier today, One River CIO Eric Peters had some very topical observations on the fate of capital markets in a world dominated by passive investing. The key excerpts:
 

“Each day since the election $1bln has moved from active to passive management,” said VICE, standing in the shadow of America’s mountain of private wealth assets. When you buy the S&P 500, you pay the prevailing price for every one of those stocks. “There is no such thing as price discovery in index investing.” And there will be no price discovery on the downside either. The stocks that have been blindly bought on the way up will be blindly sold.“ When these markets do finally have a correction there will be no bid for many of these stocks.  

 

 

“I don’t know when the next major crisis will hit, no one does,” admitted VICE. “But I do know that even in the next normal correction, the market’s losses will be amplified enormously by this move away from active management.” $500bln has shifted to index investments, distorting the way equities are valued and the historical relationship between short sellers and buyers. This flow creates artificial demand for poor-quality securities that have few natural buyers. “And now even Warren Buffett is telling investors to shift to passive.”

It is this theoretical framework for the next crash that Clark posits as the thesis for his next round of shorts.

Citing the transition from active to passive as a catalyst that makes markets even more inefficient, something Peters noted in his own weekly note, Clark repeats a lament made by many short sellers, stating that there "are complaints from some quarters about it being harder to short sell as flows of money push up stocks."

So what is his new shorting philosophy? This is how he explains it, using his biggest short at the moment, retail REITs:

The biggest short sector in the fund are REITs. In the US, they are mainly retail REITs, and there are two reasons for this. One is that we have guaranteed sellers in the Japanese US Reit fund. The other reason is the appalling performance of the major tenants. However, as an aside, I like them as a short area as they have the highest exposure to ETFs of any sector.

 

Bloomberg allows you to find the biggest ETFs and open ended funds which are invested in US Real Estate Sector. The top 28 funds have total assets of 187bn USD, of which 13.3bn USD invested in Simon Property Group, that is 24% of Simon’s market cap. However, Real Estate passive funds are not the only passive fund invested in Simon. When all passive funds weights are added together I get over 50% of Simon Property Group shareholders are passive. I wonder who will become the buyer if all these funds start to see redemptions if there are some problems in US commercial real estate?

His conclusion:

The long bull market in passive investment has made them wilfully blind to the liquidity risk that they are running. Passive investments are concentrated in the US market...

Well, if Peters is right, "when these markets do finally have a correction there will be no bid for many of these stocks", so all Clark has done is tighten the universe of ETF unwinds from the entire market to a market sector or subset of stocks, in this case the retail REIT space.

What is most interesting about the new Horseman approach, however, is that it combines fundmentals - in this case the declining purchasing power of the US consumer and the secular shift to online buying - with market inefficiency in the form of ETF flow that have pushed stock prices ever higher from their "fair value" in anticipation of an eventual sharp move lower as ETF inflows finally reverse. That said, it was not immediately clear what the catalyst for this reversal in ETF flows would be.

In any case, one can, and we assume will, repeat the exercise for all other sectors, and stocks, that have a substantial exposure to ETFs, and slowly but surely the shorts will start to accumulate, putting further pressure on sectors and stocks that have been abnormally influenced by passive flows, until finally the money flow support breaks, leading to a crack in the current market topology, potentially followed by the next market correction, or worse.

For now, however, that particular inflection point is far away. As we discussed on Friday, while active investors continue to suffer, passive vehicles such as ETFs are unable to hold the inflows: consider that according to Bloomberg's Eric Balchunas in the first quarter Vanguard alone took in $121 billion, amounting to an unprecedented $2BN per day, and was 46% better than any other Q1. Should the inflows into ETFs continue, Vanguard is on pace to rake in a record $480Bn for the year. Meanwhile, active investors, such as Rusell Clark, are praying that the reversal point comes soon, ideally before all of their funds are redeemed by investors who are tired of paying 2 and 20 for ongoing market underperformance.

Russell Clark's full letter is below:

Your fund lost 1.1% net this month. Losses came from the bond book and the long book, while the currency book and short book made money.

 

I am encouraged that the short book made money this month. When we were taking out emerging market shorts from the short book in January and February, I was very keen to keep as much US focused shorts on as possible. And it is these shorts in US retail, REITS and Autos that have performed well in March. While some of the mining stocks in the long book were weak, other related names were strong. The net effect is that the equity book was flat in March. All of the losses came from bonds, and we have sold the long-dated bunds from the portfolio while keeping the short dated bunds.

 

I am not a particularly big fan of the idea that markets are efficient. In fact I think people who believe this have never spent any time working in investment management. Everyone in the industry has seen how investment fads wash over the industry from time to time, only to wash out again as returns begin to disappoint. Making money is hard, and most investment managers, either overtly or discretely will seek to have momentum in their strategy. I would say that almost all investors have realised that this is a big part of hedge fund strategies, and have increasingly looked to cut the middle man out on this. For me this has been a big part of the rise in ETF and other passive funds. The rise of the ETF has certainly put pressure on the active fund management sector to cut its fees. There are complaints from some quarters about it being harder to short sell as flows of money push up stocks.

 

I see things differently. I like to short sell, an area that ETFs have so far failed to have any meaningful success. I like to short sell in size, but to not use index linked futures and options. So I need to short a number of stocks in a sector to get my short exposure. The growth in ETF and passive investing has been a godsend in this matter. Not only do they give you full exposure in what they own, you can also pretty closely track flows into and out of the funds. This has greatly simplified one of the big questions I always ask myself before short selling anything – who is going to sell this to force it down? The answer now, for almost all stocks, are ETFs.

 

The biggest short sector in the fund are REITs. In the US, they are mainly retail REITs, and there are two reasons for this. One is that we have guaranteed sellers in the Japanese US Reit fund (see note entitled ‘Japanese US REIT Funds and the Buy Case for Yen’). The other reason is the appalling performance of the major tenants (see note entitled ‘Mall Rats’). However, as an aside, I like them as a short area as they have the highest exposure to ETFs of any sector. Bloomberg allows you to find the biggest ETFs and open ended funds which are invested in US Real Estate Sector. The top 28 funds have total assets of 187bn USD, of which 13.3bn USD invested in Simon Property Group, that is 24% of Simon’s market cap. However, Real Estate passive funds are not the only passive fund invested in Simon. When all passive funds weights are added together I get over 50% of Simon Property Group shareholders are passive. I wonder who will become the buyer if all these funds start to see redemptions if there are some problems in US commercial real estate?

 

Fund management and investing are like all industries, subject to cycles. The long bull market in passive investment has made them wilfully blind to the liquidity risk that they are running. Passive investments are concentrated in the US market. The US bull market is getting long in the tooth, while the emerging market bull market is just starting. Your fund remains long emerging markets, short developed markets.