Feature Stories | Feb 09 2012
By Greg Peel
Short sellers are not the Devil Incarnate. Well, not necessarily anyway. This was, however, the pervasive view among many smaller investors in the great wealth rout of 2008. “Short selling should be banned,” they screamed, loudly and to anyone who would listen. And for a short time, across the globe, short-selling was indeed banned, particularly in financial stocks.
It is indeed true that the fates of over-leveraged Australian stocks such as Babcock & Brown and ABC Learning, among others, were sealed rather more rapidly in this period than time would otherwise have achieved by hedge funds relentlessly “naked” short-selling and seemingly profiting from the misfortune of others. Especially others who were slow to react or in denial about what was actually going on. It is safe to assume that the loudest protests came from those who were previously unaware short-selling was permissible, or even possible. I mean, how can you sell something you don't own?
Yet short-selling has been permissible for decades and has consistently existed as a legitimate trading strategy in all markets – bull, bear and sideways – over that time, not just in times of stock market crash. Bans were imposed by regulators in the 2008 crisis but were subsequently lifted when the dust settled. In Australia, the regulatory response was more concentrated on eradicating “naked” short-selling, rather than short-selling per se.
A short seller can actually sell something he doesn't own, but only after he has borrowed it first. Custodian businesses and large mutual funds holding enormous core stock positions are eager stock lenders as a means of enhancing returns. A fee for borrowing is charged and that cost varies with stock availability and market volatility, but might be around the 25 basis point mark under normal circumstances. That doesn't seem like much, but there is an awful lot of short-selling going on. “Naked” short-selling refers to the practice of selling a stock without having borrowed it first, safe in the knowledge you will buy it back very quickly at a lower price and no one will be any the wiser. In Australia, naked short-selling was always banned but since 2008 ASIC has become a lot more vigilant in policing the practice.
It is easy, but actually ignorant (in the true sense of the word), to assume every short sale reflects a simple desire by the seller to profit from a fall in stock price. Short-selling is also very much a part of derivatives trading in which market-makers take the other side of trades in stock options or warrants, for example, or proprietary traders look for mispricings in index futures, hybrid issues, or any manner of more complex strategies. In such cases, short selling is for hedging purposes, not for unilateral profit purposes. These are the sought of activities they first gave “hedge funds” their name, even though that label has in most cases become a misnomer in the twenty-first century.
One of the most active cohort of short-sellers in any stock market is that of the so-called long-short funds. And the expression “long-short” is the basis for this article.
It is a fact of life that small investors only ever become upset when stock markets are going down and you'll never hear boo out of them when stock markets are going up. That is not to criticise small investors, because they are simply exhibiting that which we call “human nature”. It is also a truth universally acknowledged that when your share portfolio is making money it's because you're a genius, and when it's losing money it's clearly someone else's fault. An easy target of the “someone else” variety in 2008 was your short seller.
Why is short-selling encouraged, nay even allowed by regulators? Surely all short-selling does is stop innocent people making money on their shares? The reason is history has proven that your average market is “irrational”, which again harks back to simple human nature. Not only do markets whip themselves into a frenzy of panic when prices are spiralling down, they also whip themselves into a fervour of unbridled exuberance when prices are running hard to the upside, exacerbated by the panic of missing out. Indeed, we all know that markets, and the individual stocks therein, are always at some point either under- or overvalued. On such perception, we attempt to buy stocks that are undervalued and sell them when they're overvalued.
The restriction here is that an investor cannot exploit overvaluation if the overvalued stock is not already part of their portfolio. While you may not get poor, you certainly won't get rich by not buying stocks. And a stock price is not going to stop running to the upside just because there is a growing group of investors refusing to buy it. Only when those investors holding that stock decide to get out do we see the turn around in stock price that others have already deemed inevitable. Often when that happens, in comes Mr Panic. The resultant stock price plunge can be exquisitely spectacular.
That's not much fun for the investor who was a bit slow off the mark, or worse still the investor who tried to convince himself it'll be alright – the stock will bounce back soon. Stock markets throughout history have been littered with such corpses.
When stock prices plunge dramatically, there is always, eventually, a safety net in the form of buyers looking to pick up an oversold bargain. But who might provide a safety net to the upside, or a tether if you will, saving the over-exuberant investor and the Johnny-come-lately from his inevitable fate in buying a stock already overbought?
You with me?
Short-selling, when transparently and legitimately transacted, is encouraged by regulators as a way of restricting dangerous market volatility. Legitimate short-sellers are the tether for runaway markets and potentially an inexperienced investor's best friend. Short-sellers help to keep a lid on market irrationality. That doesn't mean short-sellers know something you don't and are always right, any more so than buyers know anything more than you do. It's just that they're looking at the market from the other side of the value assessment.
A typical investor's stock portfolio is one filled with stocks the investor hopes will rise in price. It may also contain some “defensive” stocks which are there because they don't tend to fall as much in price when everything else does. A “passive” stock fund manager will simply hold those stocks in an index according to their index weightings. An “active” fund manager will overweight those stocks he expects will outperform the index and underweight those stocks he expects will underperform the index. In all “long” portfolio cases, the only way to benefit from a stock the investor believes will fall in price is to sell 'em if you got 'em, or simply not buy them. As noted earlier, not buying is not quite the path to unbridled wealth.
However, were an investor to buy those stocks he thinks will go up and short-sell those stocks he thinks are going down, he has opened up a whole new opportunity for portfolio enhancement. And, of course, he has opened up a means of actually losing money twice. But with a bit of common sense, long positions can be mostly enhanced with short positions and double-losses mostly avoided. The trick is to play the relativities, working both your “alpha” and your “beta” risks.
To understand the difference between alpha and beta risk consider an Australian copper miner who elects to alert the market of a massive new copper deposit it has just unearthed on a morning after the Dow Jones has fallen 400 points due to some problem in Europe, say. Virtually all stocks tumble from the open of the Australian market, including all copper miners, except for the copper miner in question which manages a nice gain against the tide. The “tide” is the general market, which is open to general market risk known as beta risk. The lonesome gain related to individual stock risk, known as alpha risk. All stocks will move up or down with the general market to a particular degree measured as that stock's beta. Alpha is something that can only really be noted in hindsight, but every stock has alpha risk determined by something peculiar to that one company.
We can add another area in the middle of pure alpha and pure beta when we consider a particular stock sector, although particular sector risk has no name. In the example above, the price of gold may well have shot up when the Dow fell 400 and as such Australian gold miners may have finished the day in the black when just about everything else was trashed. This is sector risk at work.
Index tracking funds hold an index-weighted stock portfolio which is a pure beta play. An individual investor may hold a disparate mix of stocks for no reason other than he thinks they might all go up, which is tending towards a pure alpha play. Alpha can never be pure because there is always an element of general market influence. This is an important point, because it means a safer way to play alpha risk is to hedge out the beta risk in a stock.
Let's say you are pretty convinced a particular coal miner could be taken over at any moment by a suitor willing to pay a substantial control premium. If right, you might make 30% plus on the day, but you can't be sure exactly when that day might be. In the meantime, the general market could tumble, or coal stocks could tumble on news of a lower negotiated coal price with Japan, perhaps, and your individual coal stock will losing you money rapidly as you wait for this elusive white knight.
But what if you short-sold another coal stock to the same dollar value of the coal stock you've bought ? What you've done is taken the beta risk out of the equation, and the sector risk, leaving only the alpha risk strategy (and hopefully reward). You don't now care so much if your long stock falls in price because your short stock is covering the losses, and you will still get your 30% if and when that day comes.
This, in a very simple form, is “long-short” trading. In this case we've matched out dollar values, which is another specific subset known as “pairs trading”. Long-short doesn't have to imply a zero dollar value investment, it simply refers to the use of short positions as an enhancement to stock portfolio trading. With thoughtful stock selection, short positions can offer enhancement by either improving profits or reducing losses over a period. Bad choices can still lead to losses on both sides of course, so this is not some gimme strategy no one had told you about before.
There is, however, one little trick the long-short portfolio manager can exploit, which we'll get to soon.
Our long-short coal stock example is one of a low risk play, but with lower risk comes lower reward. If we were to, say, play banks off against commodities we might buy CommBank and short BHP. Both have a similar beta risk in that they will rise and fall with the general market but really they have nothing else in common. History shows that the relative spread between the big resources stocks and big banks fluctuates regularly over time, including fully reversing. This is particularly influenced by foreign investors who like to play the Aussie large caps. They get carried away with the commodities trade for a while, ignoring the more plodding banks, and when it all becomes overdone they all shift the other way.
Given the lack of homogeneity between a bank and a miner such a long-short play is higher risk, but potentially offers higher reward on that basis. The greatest long-short risk/reward trade would be one in which the two stocks in question have absolutely nothing in common. Yet reasons for playing off two seemingly disparate stocks can still be clear. At present in the Australian market for example, “defensives” have become quite expensive on a relative valuation basis while some “cyclicals” are looking rather cheap. So you could perhaps make a legitimate case for (to pick something out of the blue) shorting Invocare and buying Downer EDI. Funeral services and engineering services have nothing in common, but people die no matter the economic conditions while they shy away from train contracts when things are looking dire. The market has hence bought up Invocare to overvalued levels in recent times (in stock analysts' views) and sold down Downer too far. A long-short opportunity the other way?
Long-short trading becomes more appealing in a stock market such as Australia's in which market capitalisation is highly concentrated. There are over 2000 stocks listed on the Australian Securities Exchange. Once upon a time only those of sufficient size and liquidity would make it into the All Ordinaries index, but since 2000 the All Ords has represented simply the “top” 500. The change coincided with the introduction of Standard & Poor's ASX 200 index, which is a smaller selection but little different by market capitalisation. Did you know that the lesser 100 stocks of the ASX 200 represent only 7% of market cap? [RBS Australia calculation January 30, 2012]. And that the lesser 190 stocks make up only 48%?
That's right, the top ten Australian companies represent slightly more than half the weighting of the ASX 200. This means that on any given day, all things being equal, those ten stocks are responsible for half of the daily movement of the index. Australia's problem is that we have some globally significant “biggies”, like BHP and Rio, the big four banks and Telstra, and everything else thereafter rapidly diminishes in size. This makes it easier for foreign investors to “Buy Australia” on a country rather than sector or stock-specific view because only a handful of stocks will pretty much give you “Australia”. It also implies a level of self-fulfillment of weightings if foreigners only play in the already big stocks.
It also means that the standard “long only” portfolio manager has a much more difficult time in beating the index by overweighting some stocks in the index and underweighting others. There are 181 stocks in the ASX 200 with a weighting of less than 1%, and 163 of those have weightings of less than 0.5%. There's plenty of diversification by sector in terms of what all the 200 stocks do for a living, but very little diversification by weight. Might as well just play off banks against diversified resources and cross your fingers.
One way to overcome the limits of weight concentration in the Australian market is to not just play overweight/underweight but to also play, as you might have guessed, long-short.
The equity strategists at RBA Australia decided to test this theory and so developed what they call their 130/30 Model Portfolio (not stated but one presumes the numbers represent the long/short ratio by weight). From its inception on December 3, 2010, up to January 23, 2012, the portfolio has returned 1.94%. Big whoop, say you, except that the return on the ASX 200 over the same period is minus 4.98%. The long/short portfolio has thus outperformed by 6.92%. RBS bases its success on the aforementioned trick they've learned, and that is to pay close attention to the short position report published by the Australian Securities & Investment Commission.
Each day ASIC publishes a list of all the net short positions held in each stock by ratio of market cap and all the movements in short positions over on the day, week and month. In a report published by the RBS strategists last week, they noted:
“In a November 2010 report our quantitative analyst, Eben van Wyck, demonstrated that the ASIC short interest data could be used to predict medium-term stock underperformance. He found that when there was a 25 [basis point] increase in short interest (as a proportion of issued capital) over one week, the stock underperformed its sector by 1.7% in the following three months, on average.”
The RBS strategists took van Wyck's ball and ran with it, extending the study by another twelve months, and actually took the 1.7% average out to 2.2% on an absolute return basis. They also looked at increases in weekly short interest in excess of 50bps, 100bps and 150bps. Movements of 150bps in a week resulted, on average, in that stock underperforming the market (not the sector) by 4.6%. “An interesting point to note,” the strategists suggest, “is the underperformance of stocks prior to the short-selling 'event'. This suggests,” they went on to add, and I think this is the most important factor RBS has discovered on this matter:
“Short sellers' trading strategies have an element of momentum to them.”
Last year FNArena began a new service entitled The Short Report which is published as a news story each week and tables the twenty largest short positions in the market by capitalisation and makes note of the biggest changes in short positions in each week's data, with some commentary. (Note that ASIC takes one week to compile the data so the numbers are always a reference to the week before.) The FNArena report explains in detail as a matter of course the various reasons why a stock may be shorted with the market which don't all add up to a simple belief the stock price will fall. It also explains how the data is not always 100% reliable.
[Read the latest Short Report.]
RBS has also noted the odd strange movement in weekly numbers which can sometimes prove to be an error once compared to actual trading data. To overcome such anomalies RBS “cleans” the data before applying it to portfolio selection. In layman's terms, they ignore anything that looks a bit too unbelievable.
The strategists also enhance their investigations with two further steps. The first recognises that not all of the shares on issue of a company, making up its market cap, are free-floating. If they are not free-floating they cannot be borrowed and thus cannot be shorted, so a more precise assessment can be made by rejigging the ASIC short ratios to account only for free floats.
Another filter RBS employs raises an important issue about short-selling, and that pertains to the oft heard about “short squeeze”. Short squeezes occur when a stock price is running against the short-sellers to the point they eventually bail out of their positions, only to find a lot of their peers doing the same at the same time. The less liquid the stock, the greater the squeeze will be exacerbated and the more money will be lost on the short side as the stock price runs harder. RBS employs a short weighting versus daily turnover filter in an attempt to avoid short squeezes. By using this method RBS has been able to identify average market underperformance over three months of 8.4%.
RBS has also shown by experience, nevertheless, that no system is infallible. That aforementioned 1.94% return would have been even better if not for one pesky little stock called Macarthur Coal which suddenly became a takeover target during the period, thus promoting a big speculative jump in stock price. There's not much you can do about alpha risk in its purest form, and let that be a warning to all prospective short-sellers.
But the point of the RBS 130/30 Portfolio is that it does go a long way to harnessing alpha risk in the market to provide the potential for greater than beta risk returns.
Short-selling is on an increasing trend. Over the past 18 months, RBS notes, the simple average of all stocks in the ASX 200 with short positions has risen to 1.9% of market cap from 1.2%. Smaller cap stocks have a greater short interest average than larger cap stocks. Currently, of all ASX 200 shares traded each day, 15.5% of the volume (of one side) represents short-selling. In late September that figure peaked at 30%.
RBS makes another important point. When you short a stock, you receive the sale funds. This puts more money in your portfolio “kitty” to then buy more longs using the same base amount. One could say the RBS 130/30 long-short equates to a “long only” 100. More deployment of funds means more opportunity to enhance returns. (And, of course, losses.)
Short-selling is not recommended for every investor, and indeed the smaller investor is going to find difficulty in borrowing stock given lenders will require a certain level of investment before even considering a deal. This is one for the “sophisticated investor” and beyond. Long-short plays can be implemented using long calls/long puts, long calls/short calls, or short puts/long puts, but short options have limited returns and transactions costs can be prohibitive. Contracts for difference (CFD) can be used for long/short plays but FNArena recommends only the very experienced traders consider CFD positions. There are also fee issues to overcome with CFDs as well.
For the smaller investor interested in long-short trading, the best option may be to seek existing long-short fund managers. Please remember we're only talking portfolio diversification and potential enhancement here. There's still no such thing as a free lunch.
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