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Short selling – a gamble, or prudence?

Kit Klarenberg
Written By:
Kit Klarenberg

Profiting from downward trending stocks might sound like a contradiction in terms. However, the principle forms the basis of an investment tactic – ‘shorting’.

Shorting, or selling short, is the practice of ‘borrowing’ overvalued shares from a broker and selling them in the hope the price drops.

If the price drops between the time the shares are borrowed and sold, profit is made.

“Short-selling opportunities are most commonly created by bubble markets – sectors that become seriously inflated, and sharply correct when the market turns against them,” explains Russ Mould, investment director at AJ Bell.

“Similarly, assets which trade regularly, such as stocks, also become overvalued fairly frequently. The key to shorting is identifying which securities may be overvalued, when they might decline, and what price they could reach.”

A controversial approach

Short selling is a highly controversial approach. Keith Loudon, senior partner at stockbroker Redmayne-Bentley, brands it “dangerous and reckless”.

“Short selling is a ploy for the naïve, the gambler and the crook. Leave it alone. Fingers can be burned, perhaps fatally,” he says.

Even those with a less negative view of short selling recognise the practice to be a supremely risky one. As Mould notes, the principal risk of short selling a stock is that it will in fact increase in value while you hold it, resulting in a loss.

Tom Stevenson, investment director at Fidelity Worldwide Investment, believes shorting reverses the risk trade-off of standard investing as a result.

“When you buy a share, the upside is infinite, and the downside limited to 100 per cent. With a short sale, the upside is capped at 100 per cent and losses are theoretically open-ended,” he says.

“Even if you are correct about a share being overvalued, the timing of any correction is hard to predict. In a rising market, short sellers find themselves in a more uncomfortable position than holders of shares in a falling market, who can simply hold on and wait for better times. As John Maynard Keynes said, markets can remain irrational for longer than you can remain solvent.”

As stock markets tend to go up over time, shorting is effectively a bet against the fundamental character of the market. Short selling is also typically a leveraged approach, subsidised with borrowed money.

As with any leveraged investment, investors can be vulnerable to margin calls, and consequently required to stump up more cash to maintain a position if a trade goes the wrong way.

Short selling investors also miss out on the benefits of owning a share as they are obliged to pass on dividends received while their positions are open to the owner of the shares. However, they are liable for any interest accrued on the borrowed margin.

Constructive, not destructive

Despite its controversial standing, shorting is not exclusively the preserve of high-stakes day traders. Many professional investors use the technique for constructive purposes.

“By shorting, investors can benefit from both losers and winners in a specific industry – for instance, an investor can buy up shares in a smartphone provider they expect to take market share, while simultaneously shorting another smartphone company that looks like it’s losing ground,” says Mould. This practice is known as pairs trading.

Stevenson notes some use also shorting as a hedge, to de-risk their portfolios.

“For example, an investor may short the market as a whole if they are nervous about a short-term correction, but do not wish to unwind individual stock positions about which they remain positive,” he says.

“It could be argued that shorting actually makes markets more efficient, by providing two way liquidity – otherwise financial markets might be biased towards an overly optimistic view that leads to overvaluation.”

Professional shorting

Fund managers are increasingly using shorting in their investment strategies. For Stevenson, this development is welcome, as short selling is best left to skilled professionals. As long as investors understand the risks involved and are reassured their fund manager is managing these risks appropriately, investors need not be concerned if their fund adopts the strategy.

Stephen Peters, investment analyst at broker Charles Stanley, notes funds with ‘130/30’ portfolios – funds with 30 per cent leverage to enhance returns from rising markets, plus a 30 per cent short portfolio to profit from overpriced stocks – are prevalent in the US. However this approach has as yet failed to catch on in the UK.

“Some managers are good at shorting stocks, others are not. It takes skill and experience to be able to do so, and it takes skill and experience to be able to identify managers that have that ability,” says Peters.

Given the skill and risk involved, funds using short selling strategies typically charge higher fees. While Peters believes there is no reason to necessarily avoid a fund engaged in shorting, the fees are only worth it if the manager actually adds value by doing so, so keeping a close eye on the fund’s performance is vital.

“Extra care should be taken to ensure the manager is short selling in a controlled way, that you as an investor know and understand what the manager is doing, that you understand the different risks being taken and that you are prepared to pay the higher fees you are probably being charged, and that they are justified,” he says.