36.5 LONG/SHORT RETURN ATTRIBUTION
The benefits and costs of short selling differ between retail investors and institutional investors, and the particular terms and conditions available to various institutional investors vary based on their size, the markets and securities involved, the selection of a prime broker, and so forth. Retail investors must typically post cash collateral on a short sale and are not able to earn interest on the sales proceeds received when shares are sold short. Institutional investors are typically able to earn interest on collateral or to post securities as collateral. Thus, a long/short equity manager could typically post the long positions as collateral on the short positions, thereby generating earnings on the collateral.
The institutional short seller typically receives a short stock rebate on the proceeds of the short sale. The rebate is typically an index-linked variable interest rate (e.g., the federal funds rate) minus the borrowing costs (e.g., 0.15% or 0.25% per year) that the borrower earns on the proceeds of the short sale. In unusual cases of very low interest rates or special-situation securities in which the demand for borrowing is very high, the borrowing costs can exceed the interest revenue, resulting in a negative rebate to the short seller. From the security lender's perspective, the lender is able to borrow money at the rebate rate, a rate below a riskless index, which can presumably be invested at a positive spread relative to the rebate.
The following example is stylized and is intended to represent an analysis of typical, simplified benefits and costs.
Total returns for long/short managers can be decomposed and attributed to the following four components from the long positions and four components from the short positions:
- Returns/costs from long positions:
1. Price appreciation/depreciation2. Dividends received3. Margin interest cost of longs if leveraged4. Interest earned on any excess cash or any cash posted as collateral
- Returns/costs from short positions:
1. Price depreciation/appreciation2. Interest earned on proceeds of short sale3. Cost of borrowing shares, depending on difficulty to borrow4. Dividend payments to buyers of borrowed shares
Consider a highly simplified example of a long/short manager with $100 of assets under management and only two positions:
Suppose that the objective is to attribute the total performance of this long/short fund over the specific period of one year. Also, assume that no other trades were executed over that year, that XYZ's share price rises 10% over the year, and that ABC's share price declines 5% over the same year. Assume that the short rebate of 1.5% is composed of the rate of return paid to the fund on the proceeds of the short sale (2% per year) and the cost to borrow the ABC shares (0.50% per year). Finally, assume that the fund is able to post its long shares as collateral for the short sales. Note that there is no excess cash. Exhibit 36.2 illustrates the cash flows.
EXHIBIT 36.2 Illustration of Cash Flows from Long and Short Positions
| Dollar returns from long position (XYZ): | |
| 1. Price appreciation/depreciation | +$10.00 ($110.00 – $100.00) |
| 2. Dividends received | + $2.00 |
| 3. Margin interest cost of longs if leveraged | $0.00 |
| 4. Interest earned on cash | $0.00 |
| Total dollar change from long position | +$12.00 |
| Dollar returns from short position (ABC): | |
| 1. Price depreciation/appreciation | + $2.50 ($50.00 − $47.50) |
| 2 & 3. Short rebate | + $0.75 (0.015 × $50.00) |
| 4. Dividend payments | − $1.00 |
| Total dollar change from short position | + $2.25 |
| Total dollar return | +$14.25 |
In the scenario illustrated in Exhibit 36.2, the investor would have earned a gross return of 14.25%, which is the profit of $14.25 divided by investor capital of $100. In unlevered, fully invested funds, long positions equal the amount of investor capital. In the example, the long side is fully invested and unlevered, so there is no interest income earned on cash and no margin interest expense.
The prime broker will normally examine a portfolio's characteristics to determine appropriate terms, with more favorable terms, such as lower borrowing and higher rebate rates, generally offered to larger funds. There have been periods in which prime brokers cut back on the leverage they provided their hedge fund clients, which requires leveraged funds to reduce position sizes during volatile markets.
If a long/short fund is fully invested, is unlevered, earns competitive rebates on securities with minimal borrowing costs, and has long securities with similar dividends to the securities it shorts, the returns from a long/short manager should typically be dominated by the price appreciation/depreciation corresponding to the underlying long and short positions, directly reflecting the manager's stock selection skills. Managers can also add value through market timing, when net long positions are larger during rising markets and smaller, or even net short, during falling markets.
1 For data on the performance of value versus growth stocks as well as return to momentum strategy, see http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/.
2 For a very sound and useful resource on this approach, refer to the website run by Professor Aswath Damodaran of New York University: http://pages.stern.nyu.edu/~adamodar/.