Demystifying Long-Short Funds

The benefits of a combined long/short fund: increasing the opportunity for alpha

Alpha is the output of a fund manager’s stock picking skills. It’s the ability to add value above the market return. The combination of a long/short fund gives investors a way to profit from the bad news, as well as the good. These opportunities are particularly valuable in volatile or sideways trading markets. Effectively, it adds another tool in an investor’s kit bag to generate returns but also manage risk.

Key benefits of shorting

Shorting allows investors to profit from declining share prices. Not only can this boost portfolio returns, it can also provide diversification from the traditional ‘long only’ portfolio. Being able to short stocks increases an investment manager’s opportunity set. If a ‘long’ investor finds a share to be unattractive, their options are to either sell the share if they own it or not buy it. If a ‘short’ investor finds a share they expect to fall in price, they can short the share. If their assumptions are correct and the share falls in price, they can actively generate a return.

Seven misconceptions about shorting

While shorting strategies have the potential to generate returns in both up and down markets, there are a number of myths about shorting that have stopped many investors from using these strategies within their portfolios

1. Shorting can make a company go bankrupt

Shorting a share is no more sinister than selling a share for less than you paid for it.

Assuming a company has a reasonably strong balance sheet, even if its share price fell to zero, it would still be worth the value of its balance sheet.

All shorting does is expose weak companies.

2. Shorting played a part in the global financial crisis

Prior to the global financial crisis (GFC), there were a lot of companies with over-stretched balance sheets and these were exposed during the GFC.

Shorting did not create the downward pressure on these shares during the GFC. However, because the extraordinary circumstances of the GFC, it can be argued that it compounded the pressures already at play.

3. Shorting = positive returns

While shorting provides the opportunity to profit in both rising and falling markets, not all short positions generate a positive return.

In fact, shorting is a specialist skill, as picking companies that will decline in price can often be much harder than picking companies that will rise in price.

4. Shorting is not transparent

All short selling transactions and positions are declared to the Australian Securities Exchange at the end of each trading day and are available to all market participants.

5. Shorting is not ethical

Some view shorting a company as tantamount to wanting it to fail. This is not the case.

In fact, shorting can be a benefit to the overall market because it adds liquidity, improves trading efficiency and helps to highlight where poor company management is not delivering on its promise to shareholders.

6 Shorting involves unlimited downside risk

It is true that, when opening a short position, the theoretical risk is limitless because the price of the share could increase forever.

However, a ‘stop loss’ is used by prudent managers as a risk control tool to limit the loss if a short position rises instead of falls in price.

7. Shorting doesn’t work

The positive long-term performance of market indices leads many to believe that shorting does not work.

The aim of short-selling is to profit from shorter-term factors, such as negative news or earnings downgrades, and can be used as to compliment a long portfolio that benefits from share price gains over the long term.

Source: Perpetual