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.
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 and can improve trading efficiency.
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.
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 to compliment a long portfolio that benefits from share price gains over the long term.
Source: Perpetual
If you would like to find out more about long-short funds, talk to Wynyard Park Private Wealth.
