The GameStop story brought short sellers back to the front pages of the worldwide financial press. The Reddit narrative “Main Street takes revenge on Wall Street” portrayed these short sellers because the villains of the financial markets. It also generated enough consensus buying pressure to push their positions into margin calls and realized losses.
But my focus here shouldn’t be on the GameStop story. Rather, my focus is on the necessity for each short positions and representative, investable benchmarks for personal market investing.
Money makes the world go round.
I admit that early in my profession I viewed naked short positions as a loud and disruptive component of the market. But I used to be confident that the market would find fair value and that fair value would turn out to be the transaction price.
As a trained long investor, I had quantitative concepts of fixed income, equilibrium economics, and efficient pricing models in mind, and once I dove headfirst into equity fundamental evaluation in corporate finance and public markets investing, I became fascinated with equity stories and entrepreneurial narratives. At the time, I naively believed that purely speculative short positions, those geared toward cashing in on an organization’s misfortune, contained some – yes, to illustrate it – unethical components.
Later, I learned about real investing within the stock markets and quickly realized the essential and courageous role that short positions play. Value is a goal, an expectation, the results of one of the best possible assessment process. But the value you pay or receive in actual transactions is the one objective element that counts. The amount of the transaction executed is what matters. The rest is opinion.
Short sellers are a serious kind of investor. They borrow stocks and sell them with conviction. They consider that the value they need to pay to shut their position will cover costs and produce the profit they’re looking for over an inexpensive time horizon. Conviction is vital. The ability to endure the passage of time, to attend, is the important thing execution variable. They don’t think something is a great investment per se, or a great hedge against one other investment in relative terms – the long-short case – and may finance the trade, then sell it. Period.
Talk is affordable.
What does short selling need to do with indices? When indices are investable, investors have the power to each buy and short an asset class. This implies that indices represent the asset class or the sub-allocation inside it. This signifies that taking an extended or short position in an index is a natural hedge to enhance or create a well-diversified portfolio.
Of course, this is applicable not only to up-or-down situations and macroeconomic long-short situations, but in addition to any tactical adjustment of existing asset allocations.
What makes an index investable and representative? According to accepted theory, a representative benchmark must meet seven requirements, one in all which is investability. It must:
- Will be determined upfront before the beginning of the evaluation period.
- Appropriate, in step with the investor’s investment style.
- Measurable at appropriately regular intervals and simply calculable.
- Unambiguous, in order that the identities and weights of its components are clearly defined.
- Reflects current investment opinions.
- Owned to offer appropriate accountability.
- Investable: In other words, it is feasible to carry the benchmark or its components at will.
The practice of monetary markets and the regulation of the European Union (Benchmark Regulation, EU 2016/1011) further indicate that the concept of monetary benchmarks requires a particular regulatory regime for indices used to find out the quantity to be paid or the worth of a financial instrument, to define an asset allocation or to measure performance-related fees.
Outside these limits, the concept of benchmarking loses meaning. All other products which are simply defined as benchmarks needs to be reclassified as measures for peer group comparisons, as they lack the crucial formal elements of a sound benchmark definition. If an investor cannot commonly use the relative value information of a benchmark index, that index doesn’t meet the utility requirements and is merely an afterthought. Talk is affordable.
Money makes the world go round.
Private equity (PE) is the right example of an asset class for which all currently used benchmark definitions needs to be reclassified. They function metrics for peer group comparisons and relative value evaluation ratios. For the unlisted PE industry, there is no such thing as a valid benchmark that gives a transparent performance assessment or offers adequate market risk management of investment portfolios.
For these reasons, discussions about PE returns resemble an argument between football fans moderately than an accurate performance evaluation. And I’m not only referring to future return expectations, that are by definition subjective and hypothesis-based. I mean past and current returns, which needs to be calculated ex post and leave no room for ambiguity or subjectivity. And yet they’re.
Why is it still so difficult to guage the performance of an industry with trillions in assets under management (AUM)? Industry metrics report significant absolute returns and outperformance margins, while academic studies provide differing results. None of the metrics currently in use accurately calculate the common industry performance.
I propose an objective solution. Anyone debating the outperformance or underperformance of the unlisted private equity asset class, or sub-classes thereof, should balance their financial interest with their judgment and eat their very own biscuits. Would they buy or sell their “benchmark” provisions forward? Would their benchmarks be tradable? After all, money makes the world go round.
I advocate for the event of benchmark indices that faithfully reflect the physical allocation to unlisted private equity funds and that comply with the underlying theory and regulatory requirements. The only objective criterion that ought to guide such an exercise is the short trade challenge I propose. If an investor is long the physical constituents of the index – the unlisted private equity funds – and short the index, the resulting net position needs to be zero or relatively near it, depending on the matching accuracy of the hedge position and the prices related to holding individual index constituents.
I do not see any such instrument in the marketplace in the meanwhile. This gap must be filled.
In whose interest?
The development trend of the industry is obvious. It points towards democratization. This implies the concept of product suitability.
It is within the interest of each general partners and investors to tie return expectations for personal equity to parameters that each kind of investor can understand and confirm. Benchmarks should provide this reference price out there. Such benchmarks have historically contributed to significant market growth within the asset class they’re intended to represent.
They could do the identical for personal equity, so establishing them is in everyone’s interest.
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