Short Selling – An important Risk Management Tool

Short Selling has always been the boogey man. A short sell might be described as:

1. Anti-America – because he bets on stocks going down;
2. A maniac with the risk tolerance to match;
3. Or, one of those guys that the meme stock traders made a fool of.

All of those might be true, but short selling can be effective and has its place among prudent portfolio management. Below are a couple of examples where short-selling might be useful. But first, a not useful one.

Naked short selling:

There are firms and traders that take large-short positions in individual securities speculating that they will go down in value. Some even make a good living at it. Typically, these folks are hunting fraudsters and ne’er-do-wellers and are trying to out their nefarious activities to make money. Short sellers of Valeant and Pharma Bro are a good example. Occasionally, short sellers will grow too much ego, and bet against a stock that doesn’t have one foot in the grave. An excellent example of this is Gamestop. Gamestop is ailing brick-and-mortar video game and collectable retailer, with declining revenues and earnings, and a stale board and management. However, revenues were large as a ratio to the company’s value, the company had very little debt, and short seller got overzealous and shorted a huge percentage of the outstanding company shares. Fans of the company’s product started buying the shares with reckless abandoned and caused arguably the biggest short squeeze in market history. The shorting hedge fund went out of business…quickly. Although I have serious reservations about the mania that ensued, the retail investors got this right and won. And the hedge fund closure is a cautionary tale to short sellers –when shorting an individual stock, the theoretical loss is infinity.

Now for the useful, interesting short selling strategies:

Trading a matched pair:

The concept of trading a matched pair is fascinating, and the best way to describe it is via example. Norfolk Southern and CSX are rail companies of similar size. The revenue they generate is largely from the same customers and is of similar mix. That is, they both carry freight for the same or similar companies, and they generate a similar amount of revenue from each industry they serve. NSC’s market cap is $60B, and CSX’s market cap is $72B. With incredibly thorough business and financial analysis, a determination could be made to the value of each company. Once such values are determined, one would purchase the undervalued company and sell-short the overvalued company. This strategy generally eliminates systemic and industry risk but highlights idiosyncratic risk. The punchline is that you better know which company is undervalued, or you are going to lose money. DFP does not engage in matched pairs trades.

 

Market Neutrals Strategies and Statistical Arbitrage:

Market neutral strategies are a quantitative hedge funds favorite playbook. It takes the match paired idea and distributes it across the stock universe. Using various statistical methods, hedge funds identify hundreds of stocks they believe to be over or undervalued. The fund then calculates the relative risk of the long and short portfolios and buys and sells in a ratio that minimizes volatility. Because the fund’s portfolio is equally long and short, systemic risk and excess volatility are nearly eliminated. Additionally, because there are so many holdings both long and short, the portfolio is well diversified from firm specific risk. This strategy is generally low risk but relies heavily on the fund’s investment management talent to employ the right
algorithms. DFP does not engage in market neutral strategies. Volatility reduction and reducing systemic risk For the average person the above strategies are not prudent (too much firm specific risk for naked short selling or matched pairs) or not executable (too much portfolio turnover, and short selling issues regarding tax advantaged accounts). However, when interest rates are low, asset valuations are high, and a high percentage stock portfolio is inappropriate, a hedged portfolio is appropriate. Aligning an investment portfolio to client’s risk tolerance is usually accomplished by calculating the correct proportion of stocks and bonds. Over long periods of time, the bond market returns tend to be independent to the returns of equities. So, to diversify a portfolio appropriately, the average portfolio holds about 40% bonds. However now is not an average time. Bond market yields are off historic lows and look to continue to move higher. Because bond yields are becoming more attractive and government stimulus from the pandemic is waning, equity prices are likely to fall. So, in the near-to-intermediate-term, stock and bond prices are likely to be positively correlated. The best way to hedge against stock and bond positive correlation is to avoid bonds and hedge a stock portfolio with inverse ETFs. Yes, in the financial and political markets short sellers are the butt of many jokes. And
sometimes they deserve the low reputation. However, short selling is risk reduction tool, and when used appropriately, can save client’s money and sleepless nights.