Hedge funds are paid big bucks for making smart market bets. Yet these days, a simple feature of the financial plumbing — largely overlooked on Wall Street during the low interest-rate era — is helping juice industry returns.
It’s the tidy income the masters of the universe are enjoying just on their cash proceeds after shorting stocks, all thanks to the highest federal funds rate since 2007.
When the fast-money set bets against a company, it sells borrowed shares, resulting in a pile of cash that is held as collateral with their prime broker. That cash earns interest, known as a short rebate.
Cambridge Associates, an industry consultant, has cited this benefit as one reason to be bullish on hedge funds this year — alongside all the rich stock-picking opportunities fueled by the Federal Reserve’s disruptive policy-tightening campaign. TIFF Investment Management, Morgan Stanley Investment Management and Evanston Capital, which allocate money to a range of investment vehicles including hedge funds, have said the same.
In a good year, short rebates are just a small fraction of hedge-fund returns, of course. Yet the effectively free money is offering traders a boon just as the great monetary squeeze separates the strong from the weak across Corporate America — spurring an uptick in short interest from historic lows.
With Jerome Powell & Co. pushing back against market bets on fast rate cuts this year, these mundane lending dynamics are getting more attention as the cash-is-king era powers on — and raising big questions about the hefty fees charged by some funds.
“For the first time in 15 years, the wind’s at their back on the short book,” said Joe Marenda, head of hedge fund research at Cambridge Associates. “The other aspect simply is that with higher rates, one would expect weaker companies to underperform.”
To Bill Harnisch, who oversees the $1.5 billion Peconic Partners, higher rebates are never the reason to go short, but a nice benefit nonetheless. His fund brought in $55 million in rebates last year, compared with a “fraction” of that in 2022.
“It was very noticeable, and that’s continuing into this year,” he said. “The interest income is a byproduct because we’re not going to short because of the interest.”
One rough but widely accepted way to gauge short rebates is the fed funds rate less a cost of borrow of 25 to 50 basis points. Meanwhile, the S&P 500’s dividend yield is also drifting lower, which helps bump up the rebate since funds also have to return any dividends incurred.
The short rebate was juicy enough to get a shout-out in an investor letter last year from Maverick Capital, which called it “a smaller, but still important, contributor” to returns.
“Maverick’s average net short rebate of 4.5% is the highest it has been since 2000,” wrote Lee Ainslie, a so-called Tiger Cub who founded the hedge fund. “To put that figure in perspective, our net short rebate was actually negative in eleven of the last fourteen years! Our short alpha is certainly enhanced by replacing a mild headwind with a strong tailwind.”
Source: Goldman Sachs FICC and Equities and Prime Services data as of Jan. 25, 2024
To be clear, returns derived from an elevated short rebate can be at least partly offset by higher borrowing costs on the long side when leverage is employed. Interest income is no substitute for smart investment decisions, and the actual track record of the rate-hike cycle so far is mixed.
Diversified equity funds and sector specialists managed to return 11% and 14% respectively last year, PivotalPath indexes show — a decent but far from spectacular showing even by the standards of the post-2008 era. Global macro, despite the boon of higher interest income, eked out just 1.4%, implying that many funds likely lost money from their trading.
Yet there are signs the appetite to bet against companies is growing again, after a shift in investor preferences in recent years to shorting exchange-traded funds and indexes instead. The median short interest in S&P 500 members rose to 1.8% late last year, still not far from historic lows but already the highest since 2020, Goldman Sachs Group Inc. data show.
Among the bank’s prime-brokerage clients, gross leverage has jumped to record highs, with short positions surging from a few muted years, according to a late January report.
Corporate fortunes are also diverging. The Cboe S&P 500 Dispersion Index, which measures the difference in prices of options between the benchmark and its constituents, has steadily risen since the pandemic.
“It feels like the good old days,” said Benjamin Dunn at Alpha Theory Advisors, a risk and portfolio consultancy for hedge funds, who has witnessed first-hand the short-rebate boost for his clients last year. “Zero interest rates were just a terrible environment.”
Performance Fee
For a fund with a roughly equal amount of long and short exposures, proceeds from the shorts pay for the longs, leaving the cash from investors sitting more or less in Treasury bills and the like. The same is true of macro funds trading only derivatives, since they only need to put up cash margin rather than buy any assets directly.
The easy income generated from cash these days is spurring hand-wringing among some clients given hefty industry fees. Dymon Asia Capital recently started courting investors for its multi-strategy hedge fund with a share class that will not charge performance fees until returns hit 5% for the year.
“Investors like myself are having a conversation,” said Zhe Shen at TIFF Investment Management, which allocates $7 billion for charity foundations. “‘Hold on, I don’t really want to pay you for cash management, so how about we re-look at those fees that we discussed earlier?’”
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