The Real Cost in Cost to Borrow
Alpha Theory has always incorporated the Cost to Borrow in the Risk-Adjusted Return calculation of shorts but recently we’ve improved our calculations and I’ve really been pounding the table to get clients to incorporate Cost to Borrow more formally in their decision process. For those unaware, the “Cost to Borrow” is the annualized expense charged to a manager for borrowing the shares of another investor to short in their own account. For many stocks the cost is fairly low (0-5%) but for other “Hard to Borrow” stocks, the cost can be 15-50%. “Hard to Borrow” stocks are expensive because lots of investors are suspect of the company’s prospects and want to short the shares. It is simple supply and demand.
What this means is that a 25% Cost to Borrow short would have to be down at least 25% by the end of the year to breakeven. But what if the investor believes the payback will be three months? Or, to complicate things, that there is an 80% chance the payback will be in three months and a 20% chance that the company will be able to work things out by the end of the year? Our new Cost to Borrow calculation adjusts returns by the duration and probabilities associated with the investment thesis. The concept is simple but not generally implemented. This is surprising since effectively accounting for Cost to Borrow is critical to running a good short book.
Ever since we began making a concerted effort to capture clients’ Cost to Borrow data I’ve seen how often it is being under-represented in client return expectations. Many times a client’s best short idea has a high Cost to Borrow because it is an obvious dud that others would like to short. Because of the manager’s high-conviction that the company will fail, he puts on large positions. The problem is that there may be other short ideas with slightly lower certainty or downside but also dramatically lower Costs to Borrow which make their effective return better than the high-conviction short. Now that Alpha Theory incorporates the Cost to Borrow into Risk-Adjusted Returns, clients are able to compare their short ideas on an apples-to-apples basis. Would you rather have a 40% Risk-Adjusted Return with a 30% Cost to Borrow (10% net Risk-Adjusted Return) or a 20% Risk-Adjusted Return with a 3% Cost to Borrow (17% net Risk-Adjusted Return). Of course this seems completely obvious but until it is spelled out and placed in front of the manager it is easy to let the conviction and absolute Risk/Reward sway them into oversizing the position. The message is straightforward, anyone that shorts Hard to Borrow equities should calculate a Risk-Adjusted Return adjusted for Cost to Borrow before making portfolio decisions.