There are very few areas of life where being able to “go both ways” isn’t a marked advantage. In basketball, the player who can only dribble with his dominant hand is a far weaker player, and much easier to defend than the one who can dribble equally well with both hands.
The baseball player who can switch hit is much harder for a pitcher to game plan against and is more valuable to his team because of the flexibility he provides to his manager. Zoolander’s career didn’t really breakout until he figured out how to go right, as well as left. Likewise, in investing, being a capable and competent short seller gives you a marked advantage over other market participants who are simply “long-only.”
When it comes to the global financial markets, most of the world’s money is “long-only.” Being “long-only” means that you only look for opportunities where you can buy an asset and once it appreciates, you can sell it for a profit.
Most of the world’s money is in mutual funds, pension-type funds and sovereign wealth funds. For the most part, all of this money is “long-only.” That is why a country, company or asset class, only has to be attractive on a relative basis to the rest of the world in order to get a substantial amount of money to flow its way. The US is currently a perfect example of this.
Being “long-only” obviously works because all markets including: commodities, fixed income and equities drift higher over time. But there are 2 critical reasons why short selling is an invaluable skill.
The first and most important reason to short sell, is that it allows you to dramatically improve the overall risk profile of your portfolio. I’m not going to get into a big discussion of standard deviation, beta and the like. But suffice it to say that having a process where you are actively looking to add short positions to your long positions generally results in performance that requires a lot less risk to be taken, in aggregate.
Here's a quick example from last year. Throughout last year, I discussed how my US Slow Growth Index was outperforming the US High Growth Index. For the full year, the Slow Growth Index was up 17% and the High Growth Index was up 9%.
If you were “long-only” the Slow Growth Index, you had a good year but your portfolio was fully exposed to the downside and your level of month to month volatility was just below that of the broader US equity market. However, if you had been short the High Growth Index versus your long Slow Growth Index position, you could have earned 8%, essentially risk free, and your month-to-month volatility would have been 70% less!
There are certainly some caveats to the “risk free” part of the last sentence but I think you get the picture. Yes, I realize that 8% is less than 17% but the quality of that 8% return is far superior to the quality of the higher return. Not to mention that if you were willing to use leverage, you could have actually outperformed the “long only” portfolio with substantially less volatility, but I digress.
The second reason that it’s advantageous to develop your skills as a short seller is that it opens up a whole other category of opportunities. I’m sure you’ve heard the saying “there is always a bull market somewhere.” Well, the same can be said for bear markets.
This is proven easily enough by running through 6 month charts of an array of exchange traded funds. Now, it probably won’t be half and half but some of those charts will be moving up and to the right, bull market-style, and some of those charts will be moving down and to the right in a bear market.
I quickly ran through a list of a couple of hundred markets and about 35% of them are bearish right now. Being a short seller greatly increases the available markets that I can trade. More opportunities, more profit potential. It’s that simple.
Short selling has gotten a bad rap and I hardly ever see an article, blog post, or the like on the benefits and virtues of short selling. So I’m going to dispel two of the most publicized myths around short selling and balance out the picture a bit.
Busting Short Myths
Before I start myth busting, I’m assuming that we are talking about short selling large, liquid markets, stocks or ETFs. If you choose to short penny stocks that trade 1K shares a day, First Trust ETFs that have $100K in total assets or accounts receivables for Japanese soy bean farmers, then all bets are off. Also, because markets trend up over time, shorting and holding is a fool’s errand. Short selling is a tactical maneuver.
The first myth of short selling is that the risk-reward profile of a long trade is favorable to that of a short trade. In a long trade, you only risk the amount you purchased, because a stock can’t fall further than $0 and you have unlimited upside potential.
The opposite is true for a short seller, the risk is unlimited and the profit potential is fixed, because once again, a stock or ETF can’t go lower than $0. Clearly, I’m not going to debunk the fact that a stock or ETF can go lower than $0, so I’m all good with that part of the equation. However, I take issue with the thought that a long trade has unlimited upside potential and a short trade has unlimited risk.
Have you ever seen a stock trade to infinity? Certainly, stocks can move a lot in a short period of time, but never to infinity. Also, I’ve seen just as many stocks fall hard as I’ve seen rally hard. Whether you are long or short, you always run the risk that company specific news or macro news that occurs overnight, will cause a trade to gap against you. But here again, gap risk is just as much a threat to long positions as it is to short positions.
As I’ve said before, there is no such thing as “risk on, risk off” risk is always on for both LONG and SHORT positions. While you have to have strict and well thought out criteria for choosing which markets to short and when to short them, you need that same type of criteria and attention to detail for long trade ideas as well.
It Ain't Un-American
The second myth that seems to circulate is that short sellers can cause stocks and markets to tank. This type of coverage was rampant during the Financial Crisis. During the Crisis, when Wall Street bankers went to DC, they asked for relaxation of mark-to-market accounting and a short selling ban.
When the short ban went into effect, stocks rallied for about a week and then started to decline again. Stocks don’t decline because of short sellers, rather they decline because of mismanagement or deteriorating fundamentals. More recently, the CEO of Austria’s 3rd largest bank, blamed short sellers for the decline in his stock price. The stock fell, in a very orderly fashion, from $30 to $12 over about 14 months.
Then the stock declined from $18 to a low of $9, before bouncing back to $12. This occurred, not because of short sellers, but because the market was concerned that the bank might have a capital shortfall because of its exposure to Swiss Franc mortgages in Eastern Europe. The stock declined because of the uncertainty surrounding the impact of the Swiss Franc’s rapid appreciation on the quality of the bank’s assets.
There is a very regulated mechanism in place that allows short selling to take place. It’s outside the scope of this commentary to explain that mechanism but suffice it to say that short sellers are not a source of volatility or market turmoil. In fact, short sellers are an integral part of keeping market prices orderly.
This commentary is not meant to be an exhaustive how-to guide to short selling. But hopefully I accomplished two things. First, I hope I was able to provide you with a couple of compelling reasons to further explore how you might implement short selling in your own portfolio. Second, I hope I was able to provide some balance to the seemingly negatively tinted media coverage of short selling.