Know your long stocks and manage downside risk

Equity investors may have been enjoying a bull market, but continued economic and political uncertainty has caused many to revert to products that offer the ability to both go long and short the market.

According to Charles Kantor, manager of the Neuberger Berman Long Short fund, in spite of reduced volatility, investors are still seeking a balance between “participating in rising markets and seeking to mitigate the effects of volatility”.

He says: “Shorting allows us to express a view on companies that we think are disadvantaged or poorly positioned for current circumstances. We can also add short exposure on specific sectors, geographies or market capitalisations to reduce unwanted risk.”

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Short selling is a technique that involves selling a borrowed security with the expectation that the stock price will decline. Mr Kantor describes the ability to short sell in a portfolio as “a tool that has the potential to increase returns and/or reduce risk, particularly within uncertain market environments”, although he warns: “It is important to note, however, that while shorting may hedge against certain risks, it also presents risk as the fund may be required to buy the security sold short at a time when it has appreciated in value.”

He adds: “On the long side, it’s essential to have a deep understanding of the companies you own and a sense of the key factors that may move the security. Equally important is the decision to avoid holding certain sectors of the market.”

Traditionally a tool reserved for the use of hedge fund managers, long/short strategies are increasingly becoming available to retail investors – more often through absolute return funds.

Chris Fellingham, chief investment officer at Ignis Asset Management, explains that well-managed absolute return funds “benefit from having fewer constraints than long-only strategies, with the restrictions of peer group or benchmark weightings removed and additional tools, such as shorting, in their armoury”.

“This means they should be able to deliver superior risk-adjusted returns,” he says, adding however that the sector has had a chequered past.

“While on average the sector performed well in the rising markets between 2003 and 2006, it fell in the bear market of 2006 to 2008. This demonstrated that many absolute return funds relied heavily on beta and failed to manage downside risk properly and rightly led investors to question how equipped traditional long-only managers were to manage absolute return strategies.”

A recent example of a stock that got the blood flowing among short sellers was social media site Twitter.

According to reports on Reuters, data at the start of November demonstrated a jump in the cost to borrow Twitter shares from 5 per cent to 13 per cent on an annualised basis, “indicating interest to short the stock is definitely high”.

Perhaps the most famous ‘shorting’ extravaganza of recent years was during the financial crisis, when investors attempted to profit from troubled financials such as HBOS.

So disastrous was the effect on driving down share prices during 2008 that the short selling on 29 financial stocks in the UK was banned by the then regulator the Financial Services Authority until the start of 2009.