Attending to your shorts

For entertainment value, and sometimes returns, little can match an activist short seller. Infamous Muddy Waters is the best example. It claims 19% per annum returns over the past five years, notwithstanding a decent bull market, 2.5% management cost, and 30% performance fees. Its web site provides a colourful synopsis of its short positions littered with phrases such as fraudulent, fake, garbage, and unsurprisingly, a very long disclaimer.

This raises problem number one. A few insiders along with possibly a handful of close investors would know how the fund performance was brought about, but for most it’s a closed book. This year’s hedge fund returns could just as easily have come from long holdings in tech stocks rather than the shorts. 

The widely cited global HFRI data is just as obtuse. Indices can be weighted by asset value or by average of the funds. Neither is ideal, with asset value essentially the achievement of the bemouths, Bridgewater, Renaissance, Millennium, Elliot, amongst others. Then the industry is further segmented into equity hedge, event driven, macro, relative value amongst a long list of variations on the theme.

The topic requires more than a short (sic) report. For most Australian based investors the bulk of their visible exposure is via local long-short managers and a sprinkling of market neutral strategies. Hiding elsewhere could be global macro and quant strategies that also have short positions and even relative value in fixed income.

Advisers will typically position any short strategy as a way of defending against sharp downturns in long only equities. However, the fund may not be structured to achieve that outcome. Recent returns show stellar outcomes for a number of long short funds. This can come from a relatively aggressive approach to long stocks – the market darlings or the recent rotation into cyclical stocks – coupled with net exposure well in excess of 100%. A quick perusal of monthly reports from these managers illustrates their bias. Much lauding of clever long positions, with nary a mention of what was held short, never mind the contribution.

The predominant process may therefore be more accurately described as a typical long stock focus with an element of shorting that is probably good luck than good judgement. More value appears to come from a dynamic net position where smaller funds can actively change their exposure given high turnover is usually anticipated.

There are however a few no-no’s in shorting that stand the test of time.

• Do not take on market favourites based on a view that their growth rate may not be achieved.
• Valuation is rarely a good enough premise, there has to be a short-term trigger.
• Index shorting is just what it says. It naturally will dampen the effect of a downturn but is costly in the longer term. It also means the fund is short the stocks it holds on the long side.
• Avoid high or well-known short positions or those where there is the potential for corporate interest. A squeeze looms.

Selecting a long-short manager deserves effort, given the high fees and cash benchmark. The long side has all the traditional aspects of style bias and stock selection. No matter how smart the short side may look, it will rarely override a deficiency in long stock performance. The short component has a very different lens.

There is little point in less than 10% in the short bucket of a fund – within a total portfolio this would fade into insignificance. In a market rally, one assumes the equity overweight carries the day and shorts likely suffer via underperformance, but not the intended nominal fall in value. Assuming we do enter a period where equity returns will not be determined by bond yields and momentum, short positions could prove the redeeming feature. How that short allocation is structured will then be telling.

Giselle Roux

Giselle Roux is one of Australia's most well-known and highly regarded investment strategists, having held the role of Chief Investment Officer at both Escala Partners and JB Were. She has also held a number of senior equities analyst and investment banking roles including with Citigroup, Bank of America Merrill Lynch and McIntosh Securities. Giselle is a host of Inside Network events, a member of the Advisory Committee and regular contributor to the Inside Adviser and Investor publications.