We recently covered the mechanics of short-selling in our article, ‘how short selling really works’. This followed the huge popularity of the investment strategy amid the Reddit and GameStop saga earlier this year.
In this article a number of benefits were raised ranging from the additional liquidity it provided to markets, the transparency it demanded from management of ASX-listed companies and most importantly, the ability that short-selling gives experienced fund managers to double their opportunity set.
The purpose of this article is to offer an insight into the multiple ways short-selling can be added to your portfolio. This is particularly relevant at the current time given both the S&P 500 and Nasdaq are trading at all-time highs, while the S&P/ASX 200 and Dow Jones Industrial Average are only a little way off.
While shorting is usually seen as a higher-risk strategy, market conditions suggest it may be time to flip the narrative. How confident are you that buying shares in Afterpay, Tesla or even the Nasdaq in general will be higher in six or 12 months from now, or even in three years? Long-only investing, which the majority of us practice on a daily basis, exposes you to the full downside risk of the market, on a daily basis.
Shorting on the other hand, allows investors to maintain an exposure to the market, but either reduce the impact of daily market movements on your investment, or in some cases actually benefit from them. In 2021, there are five widely accepted ways to introduce shorting to your portfolio.
Variable beta strategies
While the title may sound like jargon for most, the concept is simple. In financial markets beta is defined as the “market risk” of something like the S&P/ASX 200. Therefore, a variable beta strategy allows the manager to dial-up or dial-down the market risk, on a daily basis. That is, if they believe there are more opportunities on the short side, or that market valuations are elevated, they would choose to hold a larger level of short positions at any given time. The risk profile of these are very similar to traditional long-only equity strategies with the key determinant being stock-picking decisions.
Active extension strategies
Active extension strategies, as the name suggests, offer an extension to existing equity exposures. These strategies use short-selling to extend their views on a number of stocks within a broader index. One of the biggest issues facing investors in Australia is the high level of concentration in the S&P/ASX 200. This makes it quite difficult for “active” managers to take active positions. For instance, consider someone who didn’t want to hold Alumina (ASX: AWC), which is only 0.25% of the index. Avoiding the holding would have very little impact on returns, making it difficult to differentiate from the benchmark. On the other hand, if you were able to short-sell the company rather than just avoid holding it, your active decision can add significantly to returns. These strategies tend to fit within the ‘equity’ allocation of portfolios.
This is likely the most complex but potentially valuable option depending on market conditions. Market-neutral strategies, as the name suggests, seek to reduce the market exposure of your investment to daily market movements. This is achieved by holding the same level of long positions as short positions. Enter the complexity. In general, if you invest $1 into a market-neutral strategy, most managers will short-sell $2 worth of companies, and then reinvest the proceeds of selling those shares short, being another $2, into their preferred long positions. As you can see, as the investor, you ultimately receive around $4 worth of exposure to the market, split between companies expected to fall or rise.
The potential benefits are clear, which are the ability to protect from market corrections but also to benefit from individual stock selection ideas. This type of strategy is becoming increasingly popular as market valuations remain elevated, but particularly individual ‘concept’ and small-cap stocks. Given the leverage, this type of strategy forms part of the ‘alternatives’ allocation within portfolios.
Do it yourself
The retail investing boom has seen an explosion in the accessibility of advanced trading platforms that allow investors to trade anything from options to contracts for difference (CFDs). This type of shorting is not suitable for the vast majority of investors, as the potential losses are significant and the need for extensive risk management procedures is crucial.
Exchange traded funds
A growing number of exchange traded funds (ETFs) are now offering ‘short’ exposures through this unique listed structure. These are generally made over an entire index like the Nasdaq, S&P 500 or S&P/ASX 200. The aim of these is to deliver returns that are the inverse of the index itself, which is achieved by selling futures on the underlying index. Selling futures means you are shorting the entire index, not just one stock, and is the lowest-cost form of shorting.
There are two important definitions that prospective shorters must be aware of; that is exposure levels and short positions. Gross exposure refers to the total of both long and short positions, and reflects the leverage used by a strategy as well as the total portion exposed to individual companies. Net exposure refers to the difference between long and short positions, effectively the ‘market exposure’. Investors should seek to understand whether their managers are using index futures to reduce market risk, or as the core of their shorting strategy; as you can appreciate, the latter means that many managers would be shorting their own long positions.