In short-selling, “timing is almost more important than fundamentals,” Magnus Spence, head of investments for alternatives at Jupiter, told FSA.
The firm’s Global Absolute Return Fund is a strategy that takes both long and short positions in global equities with the aim of generating an absolute return independent of market conditions. The euro-denominated Sicav fund was launched in 2016, as a sister fund of the firm’s British pound-denominated Absolute Return Fund, launched in 2009. Both funds use the three-month Libor, in euros and British pounds, respectively, as their benchmarks.
Manager James Clunie uses analytical techniques he developed while working on his PhD in finance at Edinburgh University to manage short positions (short-selling was the topic of his 2009 PhD thesis). These techniques identify signals in the data on stock borrowing costs, the short capacity (the amount of the stock available for borrowing), the utilisation of this capacity etc., which together suggest the timing of short-sell transactions.
Selling a stock short requires strong conviction, since it carries unique risks and additional costs. In addition to potentially unlimited losses, the risks include “short squeeze” when short-sellers frantically cover their positions in a rising stock, pushing its price even higher, and “buy-ins” forced by the lender of the security demanding their shares back.
The additional costs include fees for borrowing shares, payments of dividends for which the short-seller is responsible, and margin interest, as short-selling is usually done on margin.
“There are lots of reasons why [average] investors wouldn’t short stocks,” said Spence. “Therefore, if they are shorting, they must have some informational edge which encourages them to take the risk and to pay the fees associated with shorting.”
Due to the additional cost of short-selling, short positions should not be held for a long time. While the Jupiter fund holds 140 of them, according to Spence, most are small positions. A position is increased when market signals tell the fund managers that the stock price is about to drop. One indication of an impending downturn is an increase in the number of short positions outstanding in the market.
“We are looking to identify whether the technical signals suggest if other people are starting to short stocks,” Spence explained. “When we see that, we know that it’s a good moment to increase our positions.”
Investment process
The investment process of the Global Absolute Return Fund consists of three steps. In the first step, executed once every two weeks, the investable universe of 8,500 stocks is screened based on 14 factors and whittled down to 600 names.
“We want to find stocks that are cheap and have potential to grow for the long portfolio, and on the short side we want to find stocks that look expensive and maybe have accounting fragilities or shareholder fragilities as well,” said Spence.
In the second stage, the fundamentals of the 600 stocks are analysed in more depth based on company announcements and annual reports. The two-person fund management team engages outside specialist firms to perform discounted cash flow analysis to determine the value of the companies’ shares and whether they are expensive or cheap.
The third part of the process is applied to the candidate stocks for short positions in the portfolio. Spence calls it the “ecology” part of the process.
“We seek to identify what sort of signals in the market are telling us whether other people are shorting the stock,” he said.
Stocks that the fund sells short are not necessarily bad companies.
“Our short book today comprises a lot of companies that people like,” said Spence, providing examples of Apple, Facebook, Netflix, Nestle, and Campbell Soup Company.
“We’re short these companies not because we think that they are going to go bust, but because there has been so much money seeking quality companies with strong dividend growth, we feel the valuations have become excessive.”
Strength from weakness
The short equity allocation of the fund, at 30%, is approximately equal to that of long equity (32%), making the net exposure to the equities market near zero. While short positions, which are often traded on margin, create leverage, the fund has none at the moment.
“Our strategy tends to make money when equity markets are weak,” Spence said. “When we see [the markets going up], we tend to reduce our risk and the amount of investment.”
The focus on making money predominantly off short positions results in the fund’s negative correlation with equity markets. “If equity markets go, we tend to not make any money,” Spence said. “But if equity markets go down one percent, we tend to make about 65 basis points.”
Long-short funds carry extra costs related to borrowing of shares, as part of their ongoing charges (the fund’s OCF is 1.52% according to FE). On the other hand, short-selling a stock results in a net cash position, which funds typically invest in short-term bonds for that sliver of extra income passed to investors.
Performance of the Jupiter Global Absolute Return Fund since inception, vs its benchmark and the category average
