Some fund managers will short stocks in their portfolio in order to take advantage of share price movements.
Shorting is a strategy commonly used by hedge funds and is when the fund manager takes a bet on a stock declining in value.
But short-selling is not solely used by hedge fund managers, as Colin McLean, managing director of SVM Asset Management points out.
“Although shorting is associated with hedge funds, many conventional funds and unit trusts have the power to sell short to help manage risk. This can be of individual shares, sectors or whole indices,” he says.
According to JPMorgan, in the past year to October 15, 100 stocks in the FTSE All Share index have fallen by 20 per cent or more and roughly a similar number of stocks have risen by 20 per cent or more.
“A long-only investor can only take advantage of half this opportunity set. Only investors that can short can truly take advantage of the full opportunity set in the market,” Callum Abbot, portfolio manager for the JPM UK Equity Plus Fund and JPM UK Equity Core FundJPMorgan says.
Short-selling is particularly challenging at times when stocks and sectors are moving in tandem.
So managers who use shorting strategies will be looking out for share price dispersion opportunities.
Altaf Kassam, EMEA head of investment strategy and research at State Street Global Advisors, explains: “All security selection strategies, including long/short, need dispersion in their universe to be successful, otherwise it becomes hard to generate enough excess return to justify the excess risk that was taken on.”
He notes that an ideal environment for such strategies is during times of high dispersion with moderate volatility.
“Volatility which is too low, as in 2017, means that any dispersion does not translate into significant enough differentiation in price moves.
“On the other hand, for short strategies in particular, spikes in volatility can be problematic, as they can lead to recalls and a vicious spiral, which can affect the profitability of the strategy far beyond the underlying price movement,” he adds.
Mr Abbot says that disruption has been an important theme for the past few years, with many established business models having faced structural challenges – high street retailers in particular.
However, Mr McLean believes it has been tough in recent years to short successfully.
“Low interest rates and printing money have pushed stock markets steadily higher, often giving bad companies access to cheap finance and postponing a day of reckoning,” he says.
“Despite more rapid disruption in some sectors – such as retail – short sellers may need years of patience to be proved right.”
He warns that losses from shorting are unpredictable, thereby increasing risk. And he does not see the right environment for shorting coming anytime soon.