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The long and short of it: does shorting produce better returns?

With UK stocks facing uncertainty ahead of the EU referendum, managers can make money from shorting but they must weigh up the pros and cons.

The long and short of it: does shorting produce better returns?

David Pringle

Fund manager, Kames UK Equity Absolute Return

Shorting is selling borrowed stock and buying it back for less than it was sold for. The main advantage of shorting is being able to implement your investment view fully.

If we have a negative view of a company’s share price, we can sell an amount of shares that fully reflects that view. A typical long-only fund, however, can only reflect that negative view to the extent of the company’s benchmark weight. If the view turns out to be correct, the short position will fully capture the alpha produced.

Over the medium term, across various risk-adjusted measures, long-short funds have slightly better risk-adjusted returns but a large number of long-short and long-only managers produce strong numbers. Even the best long-short managers will have periods of negative performance. It is their ability to limit the downside (not necessarily using their short book) and stick to their process that ultimately leads to better risk-adjusted returns.

Shorting risks

The main risks to our short positions come when a company is subject to a takeover bid or if it is subject to a short squeeze. The former is unavoidable in a stock-picking strategy and we have encountered it before. To mitigate the risk, we assess the likelihood of a company being acquired and adjust our position accordingly.

On the short squeeze risk, we monitor the levels of short interest across our portfolio and maintain an appropriate position size. If a short trade has worked but becomes crowded we will happily take profit and move on to the next idea.

Graham Duce

Multi-asset director, Aberdeen Asset Management

Being able to short does not necessarily result in better risk-adjusted returns. Just because a fund manager has a fantastic long-only track record, it does not mean they will be good at shorting.

Not all managers are good at shorting. A good example of a fund delivering alpha from the short book is the Artemis US Extended Alpha fund, which we hold.

Advisers should consider whether shorting is used at an index level to reduce beta in the portfolio or to pair trades in a sector. But there are more ‘directional’ shorts that increase a portfolio’s beta: for example, a value-oriented manager going long value stocks whose short book is expensive blue-chip defensives on valuation grounds.

It is important to know the beta-adjusted position of the net exposure and to monitor it closely. Investors should always understand this.

Peter Webb

Fund manager, Elite Webb Smaller Companies Income & Growth

Generally I do not consider shorting. I know it is a skill, but I think people who have taken out shorts these days go out of their way to manipulate the stock market, which is extremely dangerous.

Some short positions go well, but people are writing short positions all the time and not everyone is a winner. People were shorting companies like Quindell and Tesco like mad when they had problems. We might only see the big stories but things even out over time.

No guarantees

There is no reason why fund managers who are able to short should produce better risk-adjusted returns.

You can use shorts to manage out volatility if you can get it right, or you can take shorts out to mitigate falls in share prices, but can you find anyone who is able to predict the future? Being able to short does not make you any more of a prophet than someone who cannot or does not.

In the short-term it might be beneficial to short, but how many short-term trades do you need to get right as opposed to backing a very good business over 10 years? Arguably the latter is a better strategy.   

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