Shorting involves borrowing and selling shares of stock that an investor believes will soon decline in price. If the stock does in fact decline, the investor can buy back the shares at a lower price, and deliver the shares back to the lender. The profit for the short seller, if they are correct in predicting a price decline, comes from the difference in price from the time the stock was sold to the time it was bought back. Products that utilize shorting may help reduce volatility while uncovering additional alpha opportunities. In an interview with Asset TV, QMA Portfolio Manager, Gavin Smith explores three key advantages of shorting enabled strategies.
Expand the Opportunity Set
Shorting enabled products may unlock additional alpha opportunities. When long-only managers have an unfavorable opinion of a stock they can do one of two things: underweight it relative to the index or avoid it altogether. Long-short managers, on the other hand, have greater flexibility to take advantage of key investment insights. Stocks with an unfavorable outlook can be shorted in an effort to generate alpha in the portfolio.
Increase Return Potential
Short selling stocks provides managers with more capital to overweight attractive stocks in the long-only portion of the portfolio. Cash proceeds from the short sale of a stock can be used to extend holdings in attractive stocks, substantially increasing active exposures in a portfolio and helping to increase returns.
Cost is another factor to consider in relation to shorting decisions and return potential. Transaction cost can vary significantly from stock to stock, which can impact alpha potential. In the example below, Stock A initially appears to be the more attractive stock to short based on raw alpha potential. However, on a cost-adjusted basis, Stock B is the more attractive shorting opportunity.
Short Selling Cost Evaluation
Shorting Selling Costs
For illustrative purposes only.
Manage Market Exposure
Shorting enabled products offer diversiﬁcation beneﬁts in a portfolio, adding value in a variety of market conditions—particularly during times of falling prices. Gains from short positions may reduce overall portfolio volatility by offsetting losses from long positions and help to preserve more capital. In fact, during the ﬁnancial crisis of 2008, when the S&P 500 declined 51% long-short strategies were down 28%.1
While the concept of short selling is relatively straightforward, implementation requires experience and skill. Because shorting comes with unique risks and cost considerations, and involves the challenge of identifying attractive short selling opportunities, investors are best served with a disciplined and skilled manager at the helm.
To learn more about our shorting capabilities, read QMA’s paper The Long and Short of It. PDF opens in a new window
1Morningstar, Lipper as of 12/31/16. Calculated by PGIM Investments using data from Morningstar. All rights reserved. Used with permission. Indexes are unmanaged and do not consider fees and expenses. Long-Short is represented by Lipper’s Alternative Long-Short Equity category. Past performance does not guarantee future results
Definitions and Indices—Alpha measures risk-adjusted performance, factoring in the risk due to the specific manager rather than the overall market. Cost-adjusted alpha is the alpha adjusted for the cost associated with trading. S&P 500 Index is an unmanaged index of 500 common stocks, weighted by market capitalization, representing approximately 75% of the New York Stock Exchange. The value-weighted index represents about 75% of the NYSE market capitalization and 30% of the NYSE issues. Investors cannot invest directly in an index or average.
Diversification does not assure a profit or protect against a loss in declining markets. The comments, opinions and estimates contained herein are based on, or derived from, publicly available information from sources that Quantitative Management Associates believes to be reliable. We do not guarantee their accuracy. The material is for informational purpose only and sets forth our views as of this date. The underlying assumptions and these views are subject to change.
0308976-00001-00 Ed. 09/2017