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Absolute Return – April 2016Strategy which is sure to divide opinion
Shorting is a strategy often used by absolute return fund managers as another way to deliver returns.
But it is a technique that divides opinion, both among managers and investors, as it adds another layer of complexity to the investment process.
It is also a process akin to short-term trading, which could make some investors nervous about its use in retail funds. There are plenty of fund managers who are well practised at shorting though, and who use it regularly to enhance returns in their absolute return portfolios with positive results.
James Clunie, manager of the Jupiter Absolute Return fund, and a proponent of shorting, believes it is a simple activity, in essence.
He explains: “The reason why it’s really simple is all you’re doing by shorting is expressing a negative opinion on a stock. That’s all it is and it’s a very easy concept.
“We’re all familiar with buying a stock you think is underpriced or due to go up, [and] you have a positive opinion of it. Shorting is simply saying we think something is overpriced or we think it’s going down for some reason.
“A lot of absolute return funds make a claim they will try to outperform over some time horizon regardless of market conditions, and if you put in that kind of phraseology then you have to give yourself the toolkit that allows you to operate during good times and bad.”
| REGULATION – Using derivatives to short |
Regulation requires investment managers to use derivatives if they want to go short, as authorised investment funds are not permitted to sell assets they do not own, according to the Investment Association. The trade body states on the use of derivatives: “Managers are increasingly including the use of derivatives in their strategies to meet their funds’ investment objectives. They can also use derivatives to ‘short’ markets, shares or bonds and so potentially enhance returns at a time where prices are falling. “Regulations prevent authorised funds from physically selling shares short. Collateral must be arranged to protect the fund against the default of the counterparty to the derivative, and the amount of exposure to any one counterparty is strictly limited.” |
Short sellers generally like volatility and volatile stocks, so the first three months of 2016, for example, may have presented opportunities to go short.
Darren Bustin, head of derivatives at Royal London Asset Management, elaborates: “When volatility is high it can create opportunities for funds to exploit over both the long and short term, using a combination of both strategic and tactical investing.
“Tactical investing can exploit volatility to produce returns by taking short-term views based around technical factors in the market. This tactical investing can also potentially be used to risk manage strategic positions by offsetting them during volatile conditions.
“Adopting a philosophy that uses both tactical and strategic investments should mean a fund is able to produce returns irrespective of volatility.”
This is essentially what an absolute return fund sets out to do, and is why shorting is fairly common among these strategies.
But Brian Dennehy, managing director at FundExpert.co.uk, observes that investors who piled into absolute return funds during the market turbulence in January and February this year may have had their fingers burnt.
He notes: “Every time the market falls sharply the volume into this sector flies [upwards], even though there are bear traps in many such funds. The most obvious is that a fund has a shorting emphasis just when the market is about to turn upwards – this happened in March, hence so many poor performance numbers.”
This is one of the reasons shorting is such a divisive process: because it has more in common with trading techniques than long-term investing.
FUND PICKS Jason Hollands, managing director at Tilney Bestinvest, selects his top three absolute return funds for investors: |
Invesco Perpetual Global Targeted Returns This fund is a direct challenger to the hugely successful Standard Life Global Absolute Return Strategies fund and is similarly structured as an umbrella providing access to 25-30 underlying trades across asset classes, currencies and interest rates. The aim is to achieve a positive total return on a rolling three-year basis, with a gross return of 5 per cent per year above UK 3-month Libor. We see this fund as a ‘one-stop shop’ option for investors looking for a position in the Targeted Absolute Return sector to help reduce overall portfolio volatility. Threadneedle UK Absolute Alpha This vehicle is our top pick for investors looking for a long/short fund focused on the UK equity market. The portfolio is focused on UK large and mid caps and aims to achieve a positive return over a 12-month period, with low levels of volatility. Indeed, historic volatility over the past three years has seen the fund average just 3.1 per cent – less than one third of that of the FTSE All-Share index. JPM Global Macro Opportunities This is the flagship absolute return vehicle managed by JPMorgan’s multi-asset solutions team in London and replicates an existing offshore strategy. The fund combines an unconstrained approach to asset allocation with relative value trades and a derivatives overlay strategy, with the aim of achieving cash plus 7 per cent returns in the medium term with a 6-10 per cent volatility risk budget. The portfolio also has a competitive cost structure with a 0.78 per cent ongoing charge. |
Mr Dennehy warns shorting is not easy to get right and therefore “consistently good shorters are not common”.
“It is unnatural because it is negative, pessimistic, and most of the time most of us are naturally positive and optimistic, whether investing or otherwise. Most of the time markets, particularly equities, are going up – so you are betting against the longer-term tendency of stockmarkets.”
Mr Clunie agrees: “If you’re an investor, short selling is not really natural in that sense because it’s much more trading oriented.”
Managers who take short positions also have more to lose, he adds. “The practicalities of it are that your risk management has changed. When you own something all you can lose is all your money and when it starts to go wrong it shrinks in your portfolio. You put £100 in, it halves, and you’ve only got a £50 problem now.
“Whereas when you’re short, when it starts to go wrong – it goes from £100 to £150 – it actually grows in size in your portfolio. [Hence] your problems grow on you and there’s no limit to how bad the situation can get, so you can lose more than all your money.”
In this context, the case can perhaps be made for advisers to take a greater interest in managers’ short positions – and for managers to be more open themselves.
Ellie Duncan is deputy features editor at Investment Adviser
