The Potential Charm of Short-Selling
We know that holding a portfolio of attractive stocks has been a successful long-term strategy to build wealth. Such assets tend to appreciate over time and generate handsome gains through the math of compounding. The challenge is that stocks, as a “risky asset,” are a volatile asset class that is prone to bear market cycles and sharp drawdowns in value. As humans, many investors are shaken out of the markets at inopportune times when the going gets tough.
One tactic to address the perennial problem of volatile markets is to add the practice of short-selling stocks to a long-only equity portfolio, thus creating a long-short portfolio. Broadly speaking, two potential merits of adding an ability to short stocks are to dampen total portfolio volatility (i.e., a risk management tactic) and to generate additional alpha by permitting the fund manager to short-sell shares of companies in which he holds negative views (and to potentially generate additional alpha) instead of simply buying stocks that he expects to rise in value.
Long-short funds come in many flavors, but a typical strategy is to hold a 40% to 60% net long position (e.g., a gross long exposure of 80% to 95% vs. 20% to 50% short), which implies a very modest market beta, or sensitivity to market movements. Holding negatively correlated stock positions helps to lower total portfolio volatility typically by one-third to one-half when compared to the standard deviation of a long-only portfolio.
Expanding the Universe
Most investors are raised with a long-only bias, for several reasons. The financial media and both sell-side and buy-side security analysts tend to dwell on stocks they deem attractive and a “buy.” Besides, selling stocks short is more complex and arguably riskier than simply purchasing stocks that an investor feels are undervalued by the market. Briefly, shorting involves borrowing securities, selling them “high,” and then after (hopefully) the security prices have declined buying the same securities back “low” and returning them to the lender. Theoretically, the risk is unlimited if a stock, instead of falling in price, rises to infinity.
Yet the ability to sell stocks short is a valuable portfolio complement in the right hands. Consider the case of a long-short fund manager who conducts careful bottom-up sector and security analysis, scrutinizes balance sheets and other financial statements, and possesses powerful industry expertise and research capability. In the normal course of security analysis, the manager will comprehend industry dynamics and identify what they believe to be the winners and losers, which considerably expands the opportunity set, or universe, for taking both long and short positions in stocks.
There are always abundant opportunities to identify potential short positions among companies that have failing business models, dubious accounting, corporate mismanagement or are maybe just overvalued due to the momentum factor. But, due to some current macro and micro factors, the market seems particularly ripe for short-selling ideas (not to mention that valuations are at extremely lofty levels by history). For instance, the rapid pace of innovation and technological change are separating winners from losers in many sectors; the trend towards deglobalization and remaking of supply chains are also creating vulnerability among many companies.
Long-short managers can examine factors such as the post-Covid economy, higher inflation and interest rates, to separate the wheat from the chaff for long and short ideas within various sectors. For example, high interest rates are favorable for insurance companies (who earn much more by investing insurance premiums) and some other financial businesses but negative for mortgage lenders, homebuilders and some banks (small companies are also hurt by high rates and reduced access to credit: more than 40% of Russell 2000 companies are losing money). Within real estate, urban-center office space is being crushed by high vacancy rates due to the rise of remote and hybrid jobs; meanwhile, warehouse and industrial space is benefiting from demographic and supply-chain trends and data centers are a hot theme.
Conclusion
Thus, adding the ability to short-sell securities in a portfolio can, in the right hands, provide both a valuable portfolio hedging capability through reducing market risk and potentially augmenting returns through adroit picking of overvalued stocks. Since the art of short selling is neither simple nor without risks that are unfamiliar to many retail investors, the practice is better left in the hands of skilled professionals with the requisite experience and expertise. Once the preserve of hedge funds, fortunately there are some outstanding long-short mutual funds today.
