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Shorting deserves more respect

Long-short equity strategies have been used for a long time, but the current volatility and uncertainty plaguing the market is markedly influencing this investment approach.

While the merits of short selling and its impact on markets have been the source of much debate, the fact remains that short selling plays an important role in ensuring securities are priced correctly relative to fundamentals.

Briefly, the process of selling a share 'short' involves borrowing a stock from a broker and then immediately selling it in the expectation that the price will fall. It can then be bought back at a lower price and returned to the broker it was borrowed from, while profiting from the difference in price. 

A long-short strategy buys shares on the long side hoping they rise in price, and sells shares on the short side hoping they fall in price.

The multiple roles of shorting

Shorting is a controversial topic in Australia and has often been unfairly blamed for creating excessive volatility in markets. However, short selling doesn’t change the underlying fundamentals of a business. Shorting creates opportunities for investors with differing views, aids in price discovery and provides greater market depth.

Traditional long-only fund managers are, by definition, skewed towards identifying opportunities to buy, whereas those managers that adopt a long-short approach can take a position in a range of investment opportunities across a much wider spectrum of investment options through both buying and short-selling.

The most obvious benefit of long-short investing, therefore, is that it offers investors the ability to benefit from both rising and falling prices, whatever the market conditions. A long-short equity strategy seeks to profit from share price appreciation above the index in its long positions as well as from price declines below the index in its short positions.

From a pure risk management perspective, long-short investing can substantially lower the risk profile of a portfolio, while at the same time allowing investors to access stocks in high-performing but volatile sectors.

The technology sector is a good example. It is inherently volatile due to sensitivities around growth assumptions and bond yield movements, while simultaneously offering some of the brightest spots and rare growth companies. It would be a shame for investors to shun this sector due to volatility, and while current valuations are stretched, it need not be disregarded entirely.

In managing this risk, an asset manager will short sell companies that are less appealing yet on high valuation to remove some of the volatility. Holistically, from a pure portfolio standpoint, long-short investing should offer better risk-adjusted returns for investors.

Portfolio construction using shorts

The fund manager focusses on both short selling a range of stocks with weak investment characteristics and reinvesting the proceeds in long positions in preferred stocks, giving long-short managers a high degree of flexibility in active decision making. This is particularly relevant in the local context, given that the Australian share market is small by global standards and is dominated by a small number of very large companies.

When using a benchmark for constructing an investment portfolio, such as the S&P/ASX 200 Accumulation Index, the performance of a traditional fund which only takes long positions will be determined by the size of the fund’s shareholding of these large companies relative to that company’s weighting within the benchmark.

In contrast, a fund that is also able to take short positions by borrowing securities from other holders can sell on market then reinvest the proceeds in long positions. It creates a larger set of investment opportunities and potential to outperform the benchmark. That said, a short investment strategy is not for all investors, not least because returns and exposure are amplified on the upside as well as the downside. The most a long position can lose is the amount invested, whereas a short position can in theory lose multiple times the inital short if prices rise rapidly. 

Risk control is therefore paramount. Managers with inappropriate risk modelling will find it difficult to consistently outperform. One way to approach this is to invest in a manager that uses a combination of quantitative and fundamental investment processes.

Shorting offers diversification opportunities that would not be otherwise available to a long only manager, especially at higher levels of active risk. For instance, shorting offers the opportunity to hedge out a factor such as industry risk while allowing the benefit of stock-specific drivers of returns. Shorting is also used to leverage high-conviction long ideas within a fund.

How shorting works

Short selling opportunities should be approached in the same way as buying opportunities. Extensive research of a company's earnings prospects should be undertaken by analysing the industry structure and business model, as well as the quality of its management team, then overlay this with a top down macro-economic forecast.

The valuation is then typically referenced against peers and the earnings forecast relative to broker consensus expectations.

Once a decision is made to short, stock catalysts are then identified and an assessment of a potential holding period is made. Examples of stock catalysts include an earnings release, industry news flow, industry disruption and the prospect of regulatory changes.

Timing is important for concentrated short positions. For example, the stakes my fund recently took in lithium names such as Pilbara Minerals and Syrah previously, illustrate this. The global shift to increase electric vehicle investment had seen enormous amount of demand for battery materials such as lithium and graphite, and share prices of the sector rallied hard. In the past three years however, we have witnessed vast supply response from the raw materials producers which has meant the bullish assumptions investors initially used were grossly overstated. Those lithium positions were implemented early in the year and have been closed recently.

Increasingly, investors are realising that opting for a completely conservative investment allocation is not a viable solution. They recognise that there should be some allocation towards growth assets, and a long-short Australian equity fund may meet that criteria. The extra leverage and potential for losses on both the longs and the shorts means these funds are more suited for investors with a long-term perspective. 

Ultimately, a long-short approach enables portfolio efficiency to better capture alpha insights. This is particularly relevant with the current uncertain market outlook both globally and domestically.

 

Jun Bei Liu is Portfolio Manager at Tribeca Investment Partners. This article is for information purposes only and should not be considered investment advice.

 

3 Comments
Peter Foxton
November 18, 2019

If I borrow (or lease) your car and then sell it in the hope of buying it back more cheaply, I would be considered corrupt for selling something I don't own! I don't see shorting any differently! Furthermore, I can't reconcile profiting by investing in a business which goes down in value. The fact that smart financial engineers have figured out a way to make profits out of losses doesn't make it right. When is shorting going to be declared illegal?

Tony Dillon
November 15, 2019

Short selling is the antithesis of investor psychology, where one invests for rising values. And with unlimited loss potential, as opposed to going long where losses are limited to the purchase price of the stock, it is best left to the experts. It has a place, mainly for hedging long positions, but again, leave it to the pros. And liquidity is important, though there is no mention of that here. For those who like to spice up their investing and have a penchant for a bit of an adrenaline rush, writing naked call options will hit the spot. Another means of punting on a down market, but with leveraged loss potential. Not for the faint hearted.

Adrian
November 14, 2019

I have no problem with shorting, but I think it's worthwhile for investors to educate themselves and consider if strategies that involve shorting are right for them, as they tend to be speculative in nature. A long equity portfolio can be considered investing if the intention is to hold these assets and they are viewed as fractional ownership of businesses. I acknowledge there can be some use of shorts to hedge a portfolio, as a kind of insurance function. But the majority of these strategies are speculating that a company's share price will fall, or that the relative value between A and B will widen, etc. i.e. "A long-short strategy buys shares on the long side hoping they rise in price, and sells shares on the short side hoping they fall in price." So I don't particular like the misnomer "long-short investing". This is not investing in my way of thinking, in many cases I'd respectfully suggest it's closer to a professional form of gambling / spread betting, etc. Which is not to say it's wrong, just that "investors" should consider if that's a desireable way to deploy their capital (philosophically and temperamentally). Investors should also study the costs involved, as management fees tend to be higher in these funds, as well as the costs of borrowing shares, etc. If the fund manager is successful in overcoming these costs to generate excess returns, they will then claim a decent share of it in performance fees. Any downside however is all yours to keep. Not saying anything new here, you can also refer to Warren Buffett's $1m bet against the hedge funds back in 2007.

 

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