Your four-minute guide to short selling

Chris Salih – FundCalibre (equities, specialist investing) 

26 November 2024

Many of you would’ve seen the 2015 film The Big Short, which tells the story of the financial professionals who predicted and profited from the 2007-08 global financial crisis.

Essentially, short selling, or shorting, is a way of taking an investment position aimed around profiting from a falling share price. Investors profit when their chosen investment falls in value and lose out when it rises. It is the opposite of taking a ‘long’ position – where you expect the price of a stock to increase.

But it is a risky and complicated strategy. The Big Short highlights the sub-prime mortgage meltdown which ultimately led to the global financial crisis. It also highlights the complex financial terminology in the industry, using vivid and humorous ways to highlight complex tools (such as Collateralized Debt Obligations (CDOs) and mortgage-backed securities).

Unfortunately, FundCalibre was unable to repeat the trick by getting the likes of Ryan Gosling and Margot Robbie to “break the fourth wall” to explain certain financial jargon. So here is a quick guide to shorting and why you should only trust a skilled active manager in this challenging market.

A brief example:

As mentioned, it is possible to make money when the price of an asset falls by short selling it. You do this by entering into a contract to sell an asset that you view as overvalued, buying it back for less on a specific date. If you are right, you will make a profit.

For example, a fund manager has done the work and identified a share (a company) they feel is going to fall in value. They then borrow this share from a broker and sell them on the market when they are trading at £1.

One month later, the share price has now dropped to 70p – meaning they can benefit from the lower share price. A manager can then buy the share back for 70p, return the share to the broker and make money on the difference (30p minus trading costs).

It allows the investor to make money should they feel a share, sector, style or region is set to fall out of favour.

Don’t try this at home!

But there are plenty of dangers; your upside is really capped at two times your investment, but the downside loss is unlimited from a mathematical perspective. You also lack control and are dependent on the market, as short positions can be squeezed. A good example of this was when the share price of the American chain of bricks-and-mortar video game stores GameStop rose dramatically in 2021.

Governments can also give you a headache – they can often ban shorting or make it illegal in times of distress, potentially ruining a hedged portfolio. There is also the reality that a lot of companies do make money over the longer term, making them tough to short for a prolonged period.

When has shorting historically been used?

Timing really is everything in short selling, which is why a fund manager should be your first port of call with this type of strategy. Stocks typically fall in value much faster than they grow – remember, shorting too early can be extremely painful.

Here are a few periods which Capital Group has highlighted as being a potentially attractive environments for short selling*:

• When the market is bearish – Short selling is most fruitful when the market declines precipitously and sharply. The global financial crisis was quite the time, with short sellers making fat profits on big financial landslides. Downward trends reign supreme in a bear market.

• When the market isn’t dull – Capital Group says a common trading rule is to never short in a market that is dull, flat or has a low trading volume. It is believed that an inert market is accumulating energy before a dramatic rise.

• When fundamentals are worsening – Macro- and microeconomic fundamentals can go weak. For the overall economy and its smaller segments, deteriorating data can indicate a potential economic slowdown, bearish market sentiments or new volume lows, etc. Stock fundamentals can weaken as well. The reasons are multiple, from dropping revenue, to growing input costs, to bigger challenges a company faces. However, seasoned short sellers will never hurry up to take action. Before going short, they will wait until the bearish trend consolidates.

• When the investment is priced for perfection – Efficient market theory implies that the price immediately reflects positive predictions, including innovations, strong earnings, product launches, etc. Stocks whose value already includes positive developments are called ‘priced for perfection’. The thing is that such stocks may not grow when good news is actually released, as the improvements have already been predicted.

Once investors realise they’ve been over-optimistic, the downward phase begins. This is the best time for a short seller to kick start their investment strategy.

Timing, insight and experience are all crucial elements in short selling – done right it can offer both diversification and excess returns, but there are plenty of risks. That is why we believe it is the realm of the experienced fund manager. 

Here are a few to consider:

Janus Henderson Absolute Return

The Janus Henderson Absolute Return fund is a global long/short equity portfolio with a UK bias that aims to deliver absolute positive returns over rolling 12 month periods. Its target is to outperform the UK base interest rate, after charges, over any three-year period. Broadly, two thirds of the portfolio is in shorter-term tactical ideas, with the remainder in core holdings.

In a recent catch-up, fund manager Luke Newman said the higher interest rate environment was a benefit to the fund as it offered greater dispersion on the long and short-side of the portfolio. Speaking in July, Newman said the fund’s short book currently has around 50 names.

BlackRock European Absolute Alpha

A long/short approach is also employed by Stefan Gries and Stephanie Bothwell, the co-managers of the BlackRock European Absolute Alpha fund. Their objective is to achieve positive absolute returns over periods of 12 months, regardless of the prevailing market conditions.

The managers look for a mix of characteristics. For short ideas, they look at structurally challenged businesses, with limited pricing power, high leverage, and the potential to be disrupted. For long positions, they favour good management teams, an historically high return on invested capital, good free cash flow, and an ability to preserve capital through difficult cycles.

CT Global Extended Alpha

This is a 130/30 fund – this means the fund can employ leverage to invest more than 100% of its capital. So the manager might invest 130% long and 30% short. This would leave net long exposure of 100% (i.e. still around the same net exposure as the market).

Manager Neil Robson says this structure is a fund manager’s dream. He describes it as lining up on the starting grid for a motor race with an engine 50% bigger than everyone else’s.

The ability to short some stocks means valuable research is not wasted when the team realises a company is in trouble and it gives it another opportunity to add alpha.

Man GLG High Yield Opportunities

Man GLG High Yield Opportunities is an unconstrained, concentrated global high yield bond fund, driven by individual bond selection, but guided by top-down thematic ideas. Manager Mike Scott has an exceptional track record and has widened his investment flexibility by taking short positions in this portfolio.

*Source: Capital Group

Please Note:

This article was first published by Fund Calibre and is provided for information only. The views of the author and any people quoted are their own and do not constitute financial advice. The content is not intended to be a personal recommendation to buy or sell any fund or trust, or to adopt a particular investment strategy. However, the knowledge that professional analysts have analysed a fund or trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to make their own decisions. Past performance is not a reliable guide to future returns. Market and exchange-rate movements may cause the value of investments to go down as well as up. Yields will fluctuate and so income from investments is variable and not guaranteed. You may not get back the amount originally invested. 

Please speak to Ethical Offshore Investors or your personal adviser BEFORE you make any investment decision based on the information contained within this article.

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