Quan Nguyen

In January 2021, prominent hedge funds were making international headlines for all the wrong reasons. Terms such as ‘shorting’, ‘GameStop’ and ‘short squeeze’ were being thrown around in daily conversation, driven by a Reddit-fuelled rampage that caused unprecedented volatility in global financial markets. Given the myriad of negative publicity surrounding shorting that stemmed from the GameStop situation, many investors could be forgiven for thinking that shorting is a fool’s errand.

However, we believe that shorting is highly beneficial when used effectively. In fact, given the ability to express negative views unencumbered through short selling, a long/short manager has a significant advantage over a long-only manager, which is restricted by its mandate from expressing meaningful negative stock views.

Is the ability to express negative views an issue for Australian managers?

Over the past 20 years, the number of stocks that have a weight of less than 0.5% in the S&P/ASX 200 Index has been trending up, with the chart below illustrating this point.

From a low of 137 stocks in 2001, the number of stocks with a weighting of less than 0.5% has increased to 156 (as at 31 May 2021). What’s notable from the chart is the trend over the past three years, with stocks such as CSL and Afterpay partially responsible for the strong upward trend. These stocks have experienced extraordinary share price gains, which has resulted in an increasingly top-heavy index. Further illustrating this point is the chart below, which compares the average weight of each stock in the S&P/ASX 20, S&P/ASX 21-50, and the S&P/ASX 51-200.

It’s evident that the largest stocks overwhelm the smallest in the index, with this trend accelerating in recent years.

A typical long-only manager that seeks to take an active position (positive or negative) may easily do so on the largest stocks within the S&P/ASX 200 Index, where the stock weights range between 3% and 8%. However, as we go down the market capitalisation spectrum, it becomes increasingly difficult for long-only managers to take active underweight positions.

Let’s suppose a long-only manager dislikes a certain stock in the index that has a benchmark weight of 0.5%. To express this negative view in its strongest form, the manager would only be able to have no exposure to the stock, which is a 0.5% underweight; a relatively low conviction active position.

However, a long/short manager is unrestricted by the zero bound of index weights and may short sell to express a larger underweight position. For a skilled active manager, the more investment options available, the greater the probability of delivering strong investment outcomes.

Is Australia a good place to short?

In January 2021, prominent hedge funds were making international headlines and, perhaps for the first time ever, “shorting” was a word being exchanged in daily conversation, even by those unfamiliar with financial markets. For those investors with doubts around the efficacy of shorting after the GameStop situation, evidence from the Australian market paints an optimistic picture.

To understand the performance of short selling in Australia, we ranked the constituents of the S&P/ASX 200 Index based on the level of the share register that’s short sold. To capture the results concisely, we’ve grouped the constituents according to quintiles, rebalanced monthly.

The difference between the performance of the top quintile (most shorted stocks) and the bottom quintile (least shorted stocks) is shown below.

Although short selling both quintiles would have generated negative absolute returns, as the market has gone up over this period, shorting the top quintile would’ve been significantly less painful than shorting the bottom quintile. The difference between the two quintiles was 2.1% p.a. over this period. As such, short selling the most shorted stocks has been highly beneficial from an excess return perspective.

Investors could be forgiven for looking at this chart and believing that shorting is simple; find the most shorted stocks in the S&P/ASX 200 Index, short them, and realise strong relative gains. Although the evidence suggests that this strategy would work, we believe it’s important for investors to understand that it comes with extreme bouts of volatility.

A skilled long/short manager is crucial in navigating the market for relevant short ideas, with appropriate stock selection and portfolio management materially reducing the risks involved.

Although shorting can, and often does, result in more volatile outcomes, we believe it can be controlled and used by a skilled long/short manager to achieve strong investment outcomes. Long/short managers can achieve stronger risk-adjusted returns than long-only managers, with the short-selling capability unlocking their potential.

By Quan Nguyen, Head of Equities

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