MANAGERS WHO USE short selling strategies seek to profit from a decline in the value of stocks. The strategy involves selling a security the investor does not own in order to take advantage of a price decline the investor anticipates. Managers borrow the securities from a third party in order to deliver them to the purchaser. Managers eventually repurchase the securities on the open market in order to return them to the third-party lender. If the manager can repurchase the stock at a lower price than for what it was sold, a profit is made. In addition, managers earn interest on the cash proceeds from the short sale of stock. If the price of the stock rises, the manager incurs a loss. This strategy is seldom used as a stand-alone investment. Because of its negative correlation to the stock market it tends to produce outsize returns in negative environments, and can serve as disaster insurance in a multimanager allocation. Some managers may take on some long exposure but remain net short, or short biased. Short bias strategies are much less volatile than pure short selling exposure, but they do not provide as much upside in severely negative equity markets.

Short selling specialists borrow stock owned by a long investor and sell it on the market with the intention of buying it back later at a lower price after the market corrects itself. By selling the stock short, the short seller creates a restricted cash asset (the proceeds from the sale) and a liability (she must return the borrowed shares at some future date). Technically, a short sale does not require an investment, but it does require COLLATERAL, usually cash or relatively liquid U.S. Treasury securities. The short seller must pay any dividends paid out on the borrowed stock, so it can be costly to sell short stocks with a high yield. The proceeds from the short sale are then held as a restricted credit by the brokerage firm that holds the account and the short seller earns interest on it (the SHORT INTEREST REBATE). The amount of restricted credit is adjusted daily as the portfolio is MARKED TO THE MARKET (revalued at current market prices). As the market value of the shorted stock declines (becomes profitable), the restricted cash (the collateral) is released to become free cash, which earns a higher rate of return. If the value of the shorted stock increases (becomes unprofitable), the short seller must add to the restricted credit, either by selling other investments or by borrowing funds.

The best way to demonstrate a short seller’s source of returns is to contrast a short sale with a comparable long investment. The examples in FIGURE 14.1 on the following two pages show that theoretically a short-only portfolio of stocks that pay small or no dividends can outperform a long portfolio in certain market environments because of the added income from the interest on the collateral and the short rebate. Despite this advantage, short selling as a stand-alone strategy became very rare in the 1990s.

The bull market of the 1990s had nearly driven short selling as a stand-alone investment strategy into extinction. Besides the fact that it is hard to find overvalued stocks to profitably sell short when the whole market is charging, short selling can suffer from a number of other disadvantages that relate to market conditions. The potential losses on a long position are finite, whereas the potential losses on a short sale are infinite. Furthermore, the potential gain on a short sale is limited. If an investor shorts a stock at $50, the price of that stock can decline only to 0, a maximum of 100 percent gain. On the downside, that stock can increase in value infinitely. So if it appreciates to $150, the short seller can lose 200 percent. Because gains are limited and losses are theoretically unlimited, short sellers often have their entire net worth at stake.

As shown in FIGURE 14.2, from January 1990 to December 2004, short selling registered average annualized returns of 1.28 percent, with an annualized standard deviation of 21.51. As would be expected, these funds registered substantial returns in the retractions of 2000 and 2002 (34.63 and 29.17 percent, respectively) and a modest 8.99 percent return in 2001. However, they registered significant losses in 1999 and 2003, losing 24.40 and 21.78 percent, respectively. These types of continuous swings from positive to negative returns raise the general level of volatility for the strategy. The short seller fund’s cor-relation statistic of -0.70 reveals a high degree of sensitivity to general changes in stock prices; their beta statistic of -1.03, which measures the magnitude of correlation, shows that their returns move inversely to the prices of stocks.