Short Selling Can Result in Big Profits

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Short Selling Can Result in Big Profits
Short Selling Can Result in Big Profits

Plenty of fund investors are frustrated. During the three years ending August 16, the S&P 500 lost 7.4% annually and most funds sank into the red. But a few portfolio managers protected their shareholders by using a technique known as selling short. By taking short positions, managers profit when stocks fall. That has been a recipe for success in erratic markets.

In a typical short sale, an investor starts by borrowing stock from a broker and selling the shares. The investor waits for a while, hoping the stock will drop. Then he repurchases the stock and returns it to the broker. Say the investor borrows 100 shares of a stock priced at $10 a share. He sells the stock in the open market and pockets $1,000. Now suppose the stock drops to $8. The investor goes into the market, spending $800 to purchase shares. He takes the shares and returns them to the broker, paying off the loan. After completing the transaction, the investor holds no more shares, but he does have a profit of $200.

In a falling market, short sales can produce big profits, but can also be dangerous. Say you borrow shares and sell them, and then the stock skyrockets. You have to spend money from your pocket to buy back the expensive shares and repay the loan.

The risks of short selling

Because of the risks of short-selling, many fund managers use the strategy only selectively. The funds sell short a few stocks that seem bound to drop, but the portfolio managers keep most of their assets in conventional strategies, buying undervalued stocks that seem likely to rise. 

Among the top funds that employ some short selling is Hussman Strategic Growth, which has returned 8% annually during the past 100 years, outpacing the S&P 500 by more than nine percentage points annually. Portfolio manager John Hussman studies a range of economic indicators, including mortgage defaults and the unemployment rate. When he seems trouble ahead, Hussman sells some stocks short and holds cash.

In October 2000, he warned that a recession was coming and began betting against the market. He turned gloomy again in November 2008. In both instances, the forecast proved to be on the mark, and Hussman protected shareholders.

Another fund that sells short sometimes is Highland Long-Short Equity Fund, which has returned 1% annually during the past three years, outdoing the S&P 500 by more than eight percentage points. Portfolio manager Jonathan Lamensdorf varies the percentage of his portfolio that is dedicated to short selling. As the markets collapsed in 2008, he put half the fund into short positions. These days he has one third of assets in short positions.

While the short positions provide protection in downturns, the short holdings can suffer in bull markets and cause a fund to lag the S&P 500. Lamensdorf recognizes that the short positions can keep him from scoring outsized gains during market rallies. “Our goal is to capture 60% of the market's gains in bull markets, and only lose 30% of the market's losses in downturns,” he said. “If we can limit losses, then we will deliver competitive long-term returns.”

A balanced strategy

Some funds put half their assets in short positions and the rest in normal holdings that will benefit when the market rises. The balanced strategy ensures that at least some positions will profit—no matter what direction the market takes. One fund that keeps half its assets in short positions is JPMorgan Research Market Neutral Fund. While the short positions hold back the fund in bull markets, the balanced approach ensures that the fund rarely suffers big losses.

During the downturn of 2008, the fund recorded a small loss. But in most other years, the JPMorgan fund recorded single-digit gains. That kind of consistent showing can help to diversify a portfolio and ensure that nest eggs grow over the long term.

Advantages of hedge funds

Investors who want to benefit from short selling have long used hedge funds, the lightly regulated investment pools that are designed for institutions and wealthy individuals. Because of short selling, the hedge funds have long excelled in market downturns. The Hennessee Hedge Fund Index outdid the S&P 500 by 18 percentage points during the slump of 2008.  During the 22 years ending in 2009, hedge funds returned 12.3% annually.

Make no mistake: Hedge funds are not cheap. They charge high annual expense ratios and require initial minimum investments that start at $250,000. Besides being expensive, hedge funds can be risky. Seeking outsized returns, many portfolio managers swing for the fences and sometimes strike out. As a result, some hedge funds collapse every year—even in times of favorable market conditions.

To avoid trouble, consider using mutual funds that seek to about match the average for the hedge fund universe. Such funds will never finish in the top of the standings, but they should not land in the bottom ranks.

One of the more stable choices is Goldman Sachs Absolute Return Tracker, which requires an initial minimum investment of $1,000. During the difficult fourth quarter of 2008, Goldman lost 7%, outpacing the S&P 500 by 14 percentage points. In the downturn of the first quarter of 2009, the fund surpassed the benchmark by eight percentage points.

The fund has notable advantages over hedge funds, including lower fees. While Goldman charges an expense ratio of 1.6% of assets, typical hedge funds impose annual management fees of 2% plus performance fees that are 20% of profits.  

Another steady mutual fund is Natixis ASG Global Alternatives fund. While the portfolio managers roughly track the hedge fund universe, they sometimes depart from the benchmark to limit losses. If the market starts falling sharply, the fund will automatically lower its risk level to protect assets. The aim is to deliver steady returns. The approach worked in the first quarter of 2009. While the S&P 500 lost 11% in the downturn, the ASG fund remained about flat. By avoiding big losses, the fund can deliver the sort of consistent showing that many investors crave.

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