The mechanics of short selling

18 May 2015

Andrew Aitken, Bennelong's Head of Distribution, explains how short selling works and how this sometimes mis-understood strategy can add value.

“He who sells what isn't his'n, must buy it back or go to prison.” Daniel Drew, 19th Century US speculator.

History tells us short selling has struggled with its reputation. But short selling – selling a stock you do not actually own – is part of normal sharemarket practice albeit in reverse order. A short seller sells a stock first and buys it later. If the price falls after the sale of the shares, the short seller profits because the selling price is more than the buying price.

Many long short funds (eg. absolute return funds, market neutral funds) have as part of their mandate the ability to short sell, aiming to capture returns from both rising and falling share prices within the same fund. In this way, the fund can, in theory, generate a positive return no matter how the share market is performing.

So how does short selling work?

All short-sellers must “sell what isn’t his’n” – that’s how it works. They do this by borrowing the stock in order to sell it. Many institutional investors make extra money on their shareholdings through stock lending. Most custodians offer a product called a securities lending program, in which the beneficial owner of the stocks authorises the custodian to lend them into the market, for a fee, to borrowers who are free to use them in any way they like – although the shares always remain owned by the lender who can recall them from loan at any time.

Short positions are generally short in timeframe too, because stocks tend to rise slowly but come down quickly. One of the attractions of shorting is that if the investor gets it right, returns can be realised quickly. When done by a professional, experienced investor, there’s high potential for the fund to generate alpha (profit in excess of what a benchmark index earns).

What are the benefits?

The short component of a portfolio offers greater capital protection and ability to outperform in falling markets. However, the trade-off is that in a rising market, the short component has the potential to negatively impact overall performance.

One of the positives of a long short strategy is that it seeks to gain a performance benefit from a negative assessment of a stock at its current price. The manager analyses the stock and concludes that the share market has over-valued it and its price is likely to fall. Long only active fund managers also do these assessments, but when they form a negative judgement on a stock, they express that by not owning it at all or holding an underweight position.

A long short fund will take that negative assessment of a stock further and short sell the stock. Both kinds of managers have used identical skills to arrive at the same conclusion, but they differ in the extent to which they express that insight.

If investment managers add value through investment skill and insight, it makes sense that those skills shouldn’t only be used on the long side. A long only manager assessing a stock negatively does not always gain adequate value from that insight, but a long short manager will look to monetise that assessment.

Long short funds argue that using both directions – up and down – gives them twice the opportunity set. When done by an experienced, professional investment manager, there’s nothing untoward about short selling but rather creates an opportunity to add value in both rising and falling markets with greater capital protection than more traditional investment strategies.

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