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.”
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.
To add further transparency to the process of shorting, the European Union stepped in last November (2012), proposing a set of rules that require mandatory reporting of significant net short positions.
The EU short-selling rules state: “Each market participant has to compute its net economic short position (i.e. including short positions through derivatives) into an asset at the end of each trading session. A short position held on a share has to be notified to the relevant Competent Authority when it is equal to or greater than 0.2 per cent of the issued share capital, and has to be publicly disclosed when it is equal to or greater than 0.5 per cent of the issued share capital.”
However, due to a lack of clarity over how the rules have been set out, in October the European Securities Markets Authority admitted implementation of the regulation has been difficult.
At the Wealth Management Association’s annual conference last month, Esma executive director Verena Ross, explained: “The regulation’s aim is to create transparency in short positions to the regulator and the public at large, and also include prohibitions around uncovered short sales.
“We have spent a lot of time trying to clarify how to implement this. There are a number of areas we have indicated that need further clarification.” .
Jenny Lowe is features editor at Investment Adviser
Combining positions in a single portfolio
According to JPMorgan Asset Management, of the primary differences between various long/short strategies is the percentage of portfolio assets held short in proportion to those held long.
Depending on this exposure, these portfolios generally fall into three broad categories:
Market neutral strategies
• Market neutral strategies use equal long and short positions (typically 100 per cent long and 100 per cent short). These portfolios seek to neutralise market risk and generate positive results regardless of market direction, with little or no exposure to overall market risk.
This strategy is most suitable for investors who have accumulated cash, already own traditional assets, are temporarily out of the market and/or have reduced risk tolerance.
Long/short hedged strategies
• Long/short hedged strategies use disproportionate long/short position ranges with a long bias (for example, 100 per cent long and 70-80 per cent short). These portfolios seek equity-like returns with less risk than the overall market.
This strategy is most suitable for investors who seek to add an opportunistic component to a portfolio and/or want managers to make directional bets.
130/30 strategies
• 130/30 strategies use shorting to pursue additional performance while controlling risk (typically 130 per cent long and 30 per cent short). These portfolios seek to increase returns relative to a market or benchmark with similar risk characteristics.
This strategy is most suitable for investors who seek high total return, seek a replacement for core large cap holdings and/or want to add increased return potential to existing growth and value holdings.
Source: JPMorgan Asset Management
Using the strategy
Potential benefits
Each type of long/short strategy can play a unique role within an investment portfolio. Generally speaking, these strategies seek to either:
• Decrease risk by hedging or neutralising portfolio volatility (these are typically considered alternative investments)
or
• Enhance return potential by extending traditional strategies to allow increased exposure to an investment manager’s best ideas.
Source: JPMorgan Asset Management
