The short way to make money as share prices fall

Selling something you don't own may seem perverse, but short-selling has become increasingly common as fund managers seek to fully exploit their ability to forecast stock returns.

The concept is quite simple. The short-seller borrows shares in the expectation of selling high and buying low. If a short-seller borrows shares at 100p per share and the price falls to 90p per share, he or she can buy shares at 90p to replace the borrowed shares and keep the 10p per share as profit. Of course, if the price goes up to 110p, the short-seller must buy the shares back at a loss of 10p a share.

While ordinary investors are unlikely to do much short-selling, alternative investment vehicles such as single-stock futures and spread betting do permit smaller retail investors to try their hand. More commonly, though, the technique is the province of experienced fund managers who use it only for certain funds.

In the context of fund management, short-selling is all about stock picking. The manager is able to act on the view that a particular stock or security is overpriced or likely to underperform. If the manager has a strong negative view of a stock, short-selling enables that view to be expressed much more effectively than holding less of the stock relative to the fund's benchmark (under-weighting), or not holding it at all (zero-weighting).

There are other reasons for short-selling. One is to take advantage of perceived pricing differences between different stocks. A manager could take contrary positions in two companies whose share prices are closely related to each other: a long (buying) position in one and a short position in the other. Over time these positions would gradually be reversed (or 'unwound'), with profits earned by the price movements of the positions – assuming, of course, they move in the way the manager expects.

So-called short-sellers saw average gains of 7% in November while the FTSE 100 lost about 4.3%.

Two types of investment fund can make use of a short view. One is absolute-return funds, which look to produce a positive return regardless of market conditions. The strategies for these funds can be quite complex and often rely on sophisticated financial instruments in addition to short-selling.

The other type is the short-extension fund, which is usually benchmarked against a stock market index. Short-extension funds facilitate a limited amount of short-selling, with the short-sold shares balanced by an equal proportion of shares in other companies. In this way, the portfolio remains 100% exposed to the stock market.

One of the more popular examples of a short-extension fund is the 130/30 fund. Here, the fund manager may either invest 100% of the investment capital in long positions and add to it by short-selling an additional 30% (a "bolt-on" approach) or invest the portfolio as one entity, 130% long and 30% short (an "integrated" approach).

The higher the degree of shorting, the more opportunities the manager has to deploy his or her stock-picking acumen. But this can also increase risk, which may not be suitable for more cautious investors.

There are alternative means of gaining the benefits associated with short-selling. For instance, a series of
derivatives instruments can be tantamount to short-selling. These include single-stock futures (an agreement to buy or sell an asset at a specified price and time), single-stock put options (the right, though not the obligation, to buy or sell an asset at a specified price and time), swaps (an exchange of one series of cash flows for another), Contracts For Difference (a cash-settled agreement or contract between two parties) and forward currency contracts (an agreement between two parties to buy or sell a currency at a pre-agreed future point).

The increased risk associated with short-selling means that managers need to have proven stock-picking skills to identify appropriate short-selling opportunities – which, of course, underlines the need for rigorous, careful analysis.


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