Short-Sale Proceeds, Open Positions, and Hedge Fund Returns
Summary
The document raises an accounting and performance-measurement question about short selling. It describes a fund borrowing shares, selling them to receive cash, and later buying them back, then asks how to treat the initial sale proceeds when the short remains open at a performance-reporting date. In particular, it wonders whether recording the cash as a return could inflate reported performance, or whether the trade’s result is recognized only when it is closed.
The author connects the question to concerns about stale prices and delayed marking in hedge-fund performance, including research cited for higher estimated market beta when lagged equity-market returns are included in regressions. However, the document supplies no answer about accounting treatment, valuation of open short positions, or how proceeds and liabilities are represented in performance reporting. It is therefore useful as a prompt to distinguish cash received from profit earned, but readers need an accounting or fund-reporting source to resolve the specific treatment.
Key ideas
- The document asks how short-sale proceeds are treated while a borrowed-share position remains open.
- It distinguishes cash received at the initial sale from the later cost of buying shares back.
- The author is concerned that treating sale proceeds as returns could distort reported fund performance.
- It relates the question to stale prices and delayed marking in hedge-fund performance measurement.
- No accounting answer or treatment of open-position valuation is provided.
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Full text
# How do Hedge Funds account for returns from short selling?
# How do Hedge Funds account for returns from short selling?
I was going over my notes from an Asset Pricing module yesterday and came across something interesting I hadn't thought about in a while. It was how Hedge Funds can over inflate their performance by not properly accounting for stale/out of date prices or late mark-to-marketing. And that when they evaluate their performance, they will use these stale prices (instead of the current market price) to show a divergence of exposure to the market, hence lowering their overall market $\beta$. This was empirically supported by the work of Asness, Krail and Liew when they showed hedge fund $\beta$ increasing with lagged S&P regressions.
I then thought today, how do hedge funds account for the immediate returns from short selling? I'll propose an example to clear things up. Propose a hedge fund borrows 10,000 shares of security $S$ and sells it immediately for price $P$ and time $t_{t}$. They immediately receive $10,000 \times S \times P$. Obviously, they will then use a percentage of this immediate cash to then buy back security $10,000S$ at time $T_{t+n}$ for hopefully a lower price than $P$. And their overall profit is then the difference between these 2 sums.
But if the period in which they are short happens to be when the hedge fund computes their annual returns, does this revenue boost of $10,000 \times S \times P$ get recorded in their balance sheet as returns and hence skewing their performance, even if it is technically only an open position? Or does it only get recorded on the books once they have finally closed their position?
I'm curious as to see if this is some type of accounting trick hedge funds use to inflate their performance or do they actually account for these types of trades accordingly. More than happy to provide more detail below if things need clarifying.Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.