A value investor’s approach to shorting
The idea of “shorting” or “going short” a stock has been synonymous with hedge funds from their inception. Whereas most investors can only make money when the price of a security goes up, an investor with the ability to short can also make money when the price goes down*. Both strategies make money from ‘buying low and selling high’ – in shorting, the buying just happens after the selling.
In the same way that long-only investors achieve the best returns when they follow a coherent strategy, the same applies to shorting. For the RECM Flexible Value QI Hedge Fund, we have a clearly defined shorting framework. We classify our shorting activities into various strategies:
- Outright shorts;
- Portfolio hedges;
- Position hedges;
- Relative value trades; and
- Scalpel trades.
All of these are designed to contribute to our overall gains over time – we don’t just short for the sake of shorting. This point is so important that we want to emphasize it: many investors use shorting to reduce the volatility of their returns – to achieve a smoother progression of month-to-month values for their investors. This is a very logical and pragmatic approach. However, our shorting strategy’s primary aim is to increase the fund’s returns, and it may sometimes achieve a smoother outcome, which we then count as a bonus.
*Technically, shorting a security is slightly more complex because one needs to have a relationship with a financial institution that will allow you to execute this transaction. Assuming all paperwork is in order, shorting entails borrowing specific instruments from one of the current owners, with the undertaking to return said instruments to the owner at an unspecified time in future. One then sells these instruments in the market and collects the cash. If the transaction is successful, the instruments are bought at a future date at a lower price and returned to their rightful owner. The difference between the cash received on the first sale and the cash spent on the subsequent purchase is the profit of the short seller.