Short selling provides Watermark with an additional means of expressing investment ideas while hedging market risk. In a long/short strategy, profits are made when the long portfolio outperforms the short, irrespective of movements in the broader share market. Shorts have historically contributed strongly to total returns for Watermark funds, demonstrating well-honed capabilities in this area.
Investors benefit from long/short investing in three ways:
- They access a further source of alpha in mispriced shorts (so, access to both rising and falling share prices).
- They leverage their exposure to the stock picker while increasing diversification.
- They benefit from the natural hedge against market fluctuations.
In summary, this allows the manager to take full advantage of mispricing opportunities across the value spectrum while retaining less market risk.
How do we short sell?
It is self-explanatory how profits are made from a rising share price, but how can we profit if we expect the price to fall? At Watermark we look to take advantage of both opportunities.
We can borrow the shares of companies we expect to perform poorly from other institutional investors, for a fee. We then sell these shares on market, collecting the sale proceeds. Selling shares that have been borrowed is called short selling. If we are successful and the price falls, we can then re-purchase the shares at the lower price and return them to the beneficial owner, profiting to the extent the value of the shares have fallen.
A simple example:
Investor ‘A’ expects the price of ABC Limited shares trading at $1/share to fall and the price of XYZ Limited shares also trading $1/share to rise.
He borrows 100 shares from investor ‘B’ a long-term holder, for a small fee. He immediately sells those shares, raising $100 in cash. If the price falls to 75c as expected, investor ‘A’ can then re-purchase the shares for $75. He would return the shares to the beneficial owner ‘B’ and keep the difference of $25.
This is only one side of the transaction however. Short selling is often misunderstood because investors fail to consider the investment of the short sale proceeds. Looking at a short sale in isolation is akin to looking at the cost of a loan without also considering the investment of the loan proceeds. ‘Shorts’ are first and foremost a source of additional funds for an investor, so we also need to consider the purpose of raising the funds.
As with any investment proposal we need to consider both the return on investment which is funded by the short proceeds and the cost of funding that investment via the short sale.
The cash proceeds from short sales can be either retained in cash or reinvested in other assets, the outcome is very different:
When the short proceeds are reinvested in other long positions leverage is introduced into the structure with the investor benefiting from any outperformance of the asset over the liability (short). If the proceeds are retained in cash, the investor will benefit to the extent the liability falls in value. If this position is held in a share portfolio, the short becomes a hedge for the fund’s other share investments.
Returning to our example above:
If the short proceeds from selling the ABC shares were retained in cash then ‘A’ would also earn interest on the $100 deposited. At 5% the overall profit on the transaction increases to $30.
Alternatively, if investor ‘A’ were to reinvest the short proceeds in 100 XYZ Limited shares which he expects to increase in value, he would do even better. If the shares rise to his target price of $1.25/share, he can then sell the XYZ shares for $125, with a $25 gain.
If he added that to the gain from short selling ABC Limited, the investor pockets a total return of $50 on $100 invested.
In this example the investor has profited from both sides of the transaction. Of course it can go the other way as well. A less successful investor may lose on both sides of the transaction.
In long/short investing, it does not matter whether the value of shares that have been sold short increase or fall in value, the investor is always ahead so long as the short proceeds are invested in an asset (or retained in cash) that outperforms the shares that have been sold short.