Investing Basics: Shorting strategies

How taking short positions can enhance returns and hedge against risks….writes David Kimberley

 
The most common investment strategy is to buy an asset you think is going to rise in value, or “go long” the asset. A short position is one which profits when the underlying security falls in price. Integrating short positions into a portfolio offers another source of returns. Buying stocks means you can only benefit from them going up in value. If you believe a stock is going to go down, then you can also profit from short selling it.

One way of taking a short position is short selling, where an investor borrows a stock and then sells it in the hope that it will fall in price. If it does fall in price, they buy the stock back and then return it to whoever they borrowed it from. A profit is made on the difference between the price at which they sold the stock and the one at which they bought it back. Investors can also use futures contracts, contracts for difference and put options to take short positions amongst other methods.

However, there is also a level of downside risk. Short selling theoretically exposes you to an infinite loss and if the stock you are shorting moves up in price dramatically then you can lose a lot of money. There are also costs to holding short positions – in the case of short-selling this is a premium paid to the lender of the stock.

A perhaps more common reason for taking up short positions is to mitigate risks. The goal in this instance is less about enhancing returns and instead protecting the portfolio from sizeable losses during a drawdown.

One way of doing this would be to short sell the index your investments are listed in, thereby benefitting from the outperformance of your long positions versus the index, but not the market movements. Depending on the sizing of the long and short positions, all market risk can even be removed in what is called a “market neutral” approach. This can also be achieved by taking appropriately sized positions in pairs of stocks in the same industries. Given there is a cost to holding a short position in a stock or an index, it will always detract from overall returns, meaning having the correct long investments remains critical.
 

How are long-short strategies used in practice by investment trusts?

 
While traditional long-only investment strategies dominate among investment trusts, some use shorting strategies in some form to complement their returns.

Schroder Asian Total Return (ATR), for example, uses derivatives to reduce some of the risks of investing in Asia. The managers run quantitative models which tell them when the individual countries in their universe are looking troubled or expensive. They then use derivatives to hedge out the risk of those countries while holding their high conviction individual companies.

The manager of BlackRock Throgmorton (THRG), Dan Whitestone, uses derivates to take both long and short positions. He does this via contracts for difference (CFDs). These are synthetic instruments, which means the buyer and seller never actually own or exchange the underlying asset. Instead, they just exchange whatever the difference in price was from when the contract was opened to the time it was closed.

For instance, I could buy a long CFD on Amazon shares for £100. If Amazon shares rise by 10%, I could close my CFD position and make a £10 profit, minus any trading costs.

CFDs can be used to both short the market, which means making money from falling prices, or to go long and take advantage of rising prices. This is what BlackRock Throgmorton does. Dan uses CFDs to enhance returns and may also use them to hedge against risks in the portfolio.
 

Are long-short strategies effective?

 
Shorting sounds great in theory and there is certainly a logic to hedging against risks in a portfolio or attempting to take advantage of price drops in the market.

That does not mean, however, that it is a guarantee of success. Just as its difficult to predict which stocks are going to rise in value, it’s also hard to say which companies or markets are going to lose value.

In practice that means you shouldn’t see long-short strategies as a panacea for all market volatility. Hedging can help reduce your losses but the portfolio manager needs to get things right for that to happen.

Similarly, just as you would pick a fund manager for their long-only expertise, you can look at how they go about evaluating opportunities to short the market. If you agree with their strategies, then you may want to invest in their fund.

Effectively, long-short strategies shouldn’t be viewed differently to any other investment strategy. There is the opportunity to get things right and deliver returns for investors and there is also a chance the reverse will happen.