Is now a good time to use shorting powers?

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.

One direction

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.

For short strategies spikes in volatility can be problematic, as they can lead to recalls and a vicious spiral Altaf Kassam, State Street Global Advisors

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.

“A reduction in stockbroking research on smaller and medium-sized businesses does open up more potential for surprise on disappointing results,” he notes.

“But with investment banks and stockbroking firms vying for business from listed companies, research mainly delivers positive views. All this points to a continuing difficult environment for shorting shares.”

Adrian Lowcock, head of personal investing at Willis Owen, agrees that access to cheap credit has been an issue, and has meant that investors “didn’t really need to make any big decisions and could just ride the market upwards – and we have seen certain markets, sectors and companies perform, no matter what”.

Given the uncertainty surrounding the UK’s imminent exit from the EU, is now a good time to use shorting powers?

“Sectors that exhibit high degrees of share price dispersion do present opportunities and we think the current environment will be fruitful for long/short investors,” says Mr Abbot. 

“Whatever Brexit outcome we have, there will be winners and losers, and nimble investors will benefit from the related price volatility. Those with the ability to short have a much greater ability to take advantage of this environment than those that can only take long positions.”

Timing is everything

Others in the industry are a little more cautious about whether the environment lends itself to short-selling stocks though.

Adrian Lowcock, head of personal investing at Willis Owen, says: “Making shorting decisions now on the UK is effectively making a bet on the choices of a few dozen individuals in parliament, and that is a risky thing to do.”

He suggests: “Shorting should be done on specific stocks where you can gain an advantage by doing thorough research. The UK market is largely pricing in Brexit, so could rise on the back of a deal or fall on the no-deal scenario.”

Mr Abbot adds that it will be important not to conflate Brexit relief with a change in structural drivers, citing retailers as an example.

“Department store retailers in the UK may bounce if we get a Brexit deal. However, a deal will do little to address the long-term trend of declining footfall on the UK high street,” he adds.

Juliet Schooling Latter, research director at Chelsea Financial Services, says that the timing is simply not right.

“Shorting works best when things are not moving in tandem – when managers can really focus on individual company fundamentals. At the moment it's all about the macro, which makes it hard.

“Markets are volatile but there isn't that dispersion yet,” she adds.