Hedge Funds Adjusting To Short Sale Restrictions

The latest SEC rule change that restricts the short selling of financial stocks is causing many hedge funds to reconsider some of the models they use (see WSJ article). As an added pressure, some pension funds that invest in hedge funds are asking fund managers if they have strategies that rely on shorting, causing some less diversified pension funds to consider withdrawing hedge fund investments. Many smaller hedge funds with less sophisticated back office operations are also now finding it more difficult to comply with the new SEC regulations and still respond to the market, continuing the recent trend of challenging times for small funds (see previous post). The new rules, if successful in reducing the selling pressure on stocks, may also affect hedge funds that have been profiting recently from volatility (see previous post), although the last short-squeeze and trend reversal was short-lived (yet the rule affected less than 20 companies). Are funds eager to get back to shorting? Of interest is the following:

"Now the market is popping big time, and it's going to frustrate people. Are the short sellers wishing today that they could be shorting at these levels? Yes, they are."

No doubt that some will take this quote as a further indication that the shorts simply want to drive the markets down at the expense of everyone else. Others will see this as further proof that the markets are still over-valued. Of course, such a quote could just be an admission that the new rules have in fact created an artificial SEC-induced short-squeeze. If the natural tendency is towards a reversion to market efficiency, the new rules certainly don't help us achieve this goal over the long-run, even if they do slam the brakes on what some believe might have been an over-reaction in the opposite direction.