Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 332

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.

 

Leave a Comment:

     

RELATED ARTICLES

Social media’s impact is changing markets

Reddit v hedge: GameStop rides to the moon and back

Phil King on the long and short of investing

banner

Most viewed in recent weeks

Unexpected results in our retirement income survey

Who knew? With some surprise results, the Government is on unexpected firm ground in asking people to draw on all their assets in retirement, although the comments show what feisty and informed readers we have.

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Three all-time best tables for every adviser and investor

It's a remarkable statistic. In any year since 1875, if you had invested in the Australian stock index, turned away and come back eight years later, your average return would be 120% with no negative periods.

The looming excess of housing and why prices will fall

Never stand between Australian households and an uncapped government programme with $3 billion in ‘free money’ to build or renovate their homes. But excess supply is coming with an absence of net migration.

Five stocks that have worked well in our portfolios

Picking macro trends is difficult. What may seem logical and compelling one minute may completely change a few months later. There are better rewards from focussing on identifying the best companies at good prices.

Six COVID opportunist stocks prospering in adversity

Some high-quality companies have emerged even stronger since the onset of COVID and are well placed for outperformance. We call these the ‘COVID Opportunists’ as they are now dominating their specific sectors.

Latest Updates

Retirement

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Interviews

Sean Fenton on marching to your own investment tune

Is it more difficult to find stocks to short in a rising market? What impact has central bank dominance had over stock selection? How do you combine income and growth in a portfolio? Where are the opportunities?

Compliance

D’oh! DDO rules turn some funds into a punching bag

The Design and Distribution Obligations (DDO) come into effect in two weeks. They will change the way banks promote products, force some small funds to close to new members and push issues into the listed space.

Shares

Dividends, disruption and star performers in FY21 wrap

Company results in FY21 were generally good with some standout results from those thriving in tough conditions. We highlight the companies that delivered some of the best results and our future  expectations.

Fixed interest

Coles no longer happy with the status quo

It used to be Down, Down for prices but the new status quo is Down Down for emissions. Until now, the realm of ESG has been mainly fund managers as 'responsible investors', but companies are now pushing credentials.

Investment strategies

Seven factors driving growth in Managed Accounts

As Managed Accounts surge through $100 billion for the first time, the line between retail, wholesale and institutional capabilities and portfolios continues to blur. Lower costs help with best interest duties.

Retirement

Reader Survey: home values in age pension asset test

Read our article on the family home in the age pension test, with the RBA Governor putting the onus on social security to address house prices and the OECD calling out wealthy pensioners. What is your view?

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.