Tom Goodrich

After years of bull markets that hung most short sellers out to dry, the playing field has recently levelled out, with high global inflation and wide-spread recessionary fears boding well for short selling. SVB Financial Group, Adani and Bed Bath & Beyond are three high-profile stocks that have recently tumbled or filed for bankruptcy, which allowed short sellers to profit handsomely.

It hasn’t just been an offshore phenomenon either, with short selling experiencing a resurgence in Australia over the past year. Shorting is seemingly back in fashion!

When short interest reached 10-year lows in July 2021, the market environment had been dominated by what some would argue was indiscriminate buying and investor greed. Under this backdrop, headlined by the GameStop Saga, investors were seemingly hesitant to short sell over heightened fears of irrational market behaviour. In fact, at that point, the broad market index (as represented by the S&P/ASX 300 Index) had returned 56% from the lows of the COVID-19 sell-off in March 2020. By June 2022, short interest had recovered back above its long-term average, coinciding with a market decline of 9%. As investors became weary once again, short interest reached close to its peak in October 2022.

We believe that short selling returning to historical levels in Australia is a positive, given its contribution to the efficient functioning of financial markets.

In the words of Kynikos Associates founder, Jim Chanos: “Short selling plays the role of real-time financial watchdog. It’s one of the few checks and balances in the market.”

Short selling is not for everyone

The asymmetric nature of short selling is something that’s crucial to understand, with Mohnish Pabrai, founder of Pabrai Investment Funds, summarising a crucial point: “When you look carefully at the economics of shorting, it makes no sense to take the bet. The lowest price a company’s stock can go to is zero, but there’s an unlimited upside.”

Given the risks involved, we believe successful short selling requires specialised experience and expertise. Our Australian Shares – Long/Short peer group consists of highly experienced and skilled professionals who employ thorough risk management practices, including limiting their exposure to highly shorted stocks. This mitigates the risk of extreme negative returns from rapid upward price movements (due to short squeezes).

Which sectors are unloved?

With short selling back in vogue, which market segments are expected to be under pressure? To answer this question, the following chart breaks down where short sellers are positioned from a sector perspective, as at 31 March 2023.

As shown above, basic materials and consumer discretionary companies accounted for almost half of all short interest. Lithium miners such as Sayona Mining, Core Lithium and Liontown Resources top the list of the most shorted stocks within the basic materials sector. As for the consumer discretionary sector, COVID-19 beneficiaries such as Harvey Norman, Breville Group and Temple & Webster were among the most shorted stocks.

How are the experts positioned?

The chart below shows Zenith’s Australian Shares – Long/Short peer group’s average short exposure from a sector perspective.

The consumer discretionary and basic materials sectors only accounted for 32% of all short-sold stocks, which is materially less than the market. Interestingly, industrials accounted for the highest short exposure.

We note that these short exposures are captured in isolation rather than from a holistic portfolio perspective. That is, managers may engage in pair trades, which involves holding a short position that offsets a long position. Pair trading is commonly used to take advantage of a meaningful and unjustified difference in valuations between two similar companies with comparable characteristics.

If diversification is a free lunch, then shorting must be a buffet

With the concentrated nature of the Australian equities market, it can be difficult to successfully diversify portfolios, particularly within a long-only or a low Tracking Error mandate constraint.

The chart below measures industry concentration^[1] in the Australian market (as represented by the S&P/ASX 300 Index). With a total of 11 equally-weighted sectors, a lower value suggests higher sector concentration.

As shown above, sector diversification in the Australian market had been trending upward and reached its peak in September 2020. However, since then, the trend has reversed. As of 31 March 2023, financials and basic materials^[2] accounted for over half of the Australian market. Effectively, an investment in the S&P/ASX 300 Index entailed holding an average of 5.6 equally-weighted sectors out of a possible 11 over the assessed period.

By short selling an inferior company and using the proceeds to purchase a more attractive company operating in a different industry, a long/short manager can increase portfolio diversification from a sector exposure perspective whilst expressing their stock-specific views with greater conviction.

The chart below measures industry concentration^[3] in Zenith’s Australian Shares – Long/Short peer group.

Whilst the peer group faced the same trend of increasing industry concentration from March 2020 to March 2021, managers were able to revert to higher levels of diversification, unlike the broader market. Effectively, an investment in our Australian Shares – Long/Short peer group entailed holding an average of 7 equally-weighted sectors out of a possible 11.

For ease of comparison, the difference in sector diversification between our Australian Shares – Long/Short peer group and the index is captured in the chart below. This time, the values indicate the amount of equally-weighted sectors managers held above the broader market.

Over the assessed period, the peer group consistently maintained significantly greater levels of sector diversification compared to the Australian market. We believe this demonstrates a key benefit of investing with an active long/short manager with professional experience and expertise in short selling.

How has this impacted performance?

Given the flexibility to adjust industry concentration, net market exposure and risk-taking levels depending on the prevailing market environment, we expect long/short strategies to outperform, particularly in declining markets.

Compared to the Australian market, which captured 100% of market drawdowns, long/short managers captured just 76% of the market’s declines over the assessed period. However, the managers were able to participate in over 95% of market upswings. Over the long term, this upside/downside capture ratio suggests long/short strategies can outperform by protecting investors from significant losses.

Controlling risks leads to better investment outcomes

We believe the ability to effectively control risk is paramount in achieving strong investment outcomes. Long/short managers can utilise short selling to increase portfolio diversification. This is particularly important within the context of the Australian equity market, which has seen increasing levels of sector concentration over time.

However, given the asymmetric risk/return profile of short selling, specialised experience and expertise is required to succeed.

With many investors expecting potentially turbulent market conditions, we believe superior investment outcomes can be achieved by utilising skilled long/short managers that can appropriately navigate the risks of the Australian equity market.

By Tom Goodrich, Senior Investment Analyst

——–

Notes:
[1] Calculated by 1 divided by the Herfindahl-Hirschman Index
[2] 24.1% and 27.3% respectively
[3] Calculated by 1 divided by the Herfindahl-Hirschman Index

The post The return of the shorts appeared first on AdviserVoice.