Short selling is a losing proposition for long-term investors and a waste of capital. A basic test for any investment strategy is whether or not it can generate profit over the long-term. On the basis of this test, short selling fails miserably. Not a single short-only fund has generated a positive real return (net of inflation) over the long term.
Of course, poor performance does not stop the multitude of short-selling money management firms from playing on the fears of investors. Investors are told that they need to hedge their long exposure in stocks with short selling. They are told that bear markets are inevitable and that short selling is the best way to mitigate losses.
As I will explain later, there is a far better way to hedge your equity risk than short selling. Alternatives to short selling are not widely touted on Wall Street because they do not generate nearly as much profit as short selling.
The enormous fees paid to short sellers borders on the absurd. One well-known short selling hedge fund, with billions of dollars under management, has the gall to charge a 20 per cent incentive fee (in addition to other fees) on the inverse of the S&P 500 return. If the S&P gains 15 per cent, the inverse would be -15 per cent. If the manager’s return is -10 per cent, for example, he charges an incentive fee on the 5 per cent difference, despite the fact that he lost investor capital.
The best performing short-selling mutual fund is the Prudent Bear fund, managed by David Tice. It has averaged -2.02 per cent annually since its inception (December 28 1995) and -1.29 per cent annually over the past 10 years. A study by Yale’s Roger Ibbotson found that short-biased hedge funds averaged -2.3 per cent per year from 1995 to early 2004. Short-biased funds are not 100 per cent short and can hold long positions.
The reason why short selling is a losing proposition for investors is not because short-selling money managers are incompetent. Many short-selling managers, such as Tice, are highly skilled analysts. The reason they lose investors’ capital over the long term is owing to the insurmountable structural impediments in their path.
The most obvious impediment is the risk versus reward for each short position. As most investors know, shorts have limited potential reward (100 per cent less carrying costs) since a stock can only drop to zero. Losses, though, are unlimited, since a stock that is shorted can soar to any height.
Another impediment is the relentless upward bias of the market. Over the long term, the market grows in value by 7-8 per cent a year. The source of the added value is easy enough to identify. That is, in the aggregate, businesses are profitable. The combined companies in the Dow Jones Industrial Average have been unprofitable only once in the past 80 years. That was a small loss in the midst of the Great Depression in 1932.
The accumulation of profit results in value accumulation. Value accumulation is reflected in steadily higher stock prices over time. Short sellers, then, are faced with a daunting hurdle. They have to overcome an average 40-45 per cent value increase in equities (7-8 per cent compounded) every five years just to break even (before costs).
The long-only investor has one burden while the short seller has two. The long-only investor needs to get the value right (undervaluation). The short seller has to get both the value right (overvaluation) and the timing as well. While long-only investors can sit on their hands and wait for better prices, time causes unrelenting pressure on the short seller because of high carrying costs.
It should come as no surprise, then, that history’s great investors, such as Warren Buffett, have passed on the opportunity to short stocks. Buffett could identify the obvious overvaluation of technology stocks in the late 1990s, for example, but, because he could not predict timing, he passed on the opportunity to go short.
Sophisticated investors that understand value do not need short sellers. At no extra cost, exceptional long-only managers already hedge against valuation risk by buying stocks at a discount. In the midst of a bear market, this hedge is magnified because they are able to buy stocks even cheaper. While the benefit may not be evidently coincident with a bear market, it shows up later in the form of robust performance.
Cash is a vastly superior hedge to short selling. For no fee, investors can get a government-guaranteed return over and above inflation for their cash holdings. A portfolio that is, for example, 80 per cent long and 20 per cent invested in inflation-indexed Treasuries is vastly superior to one that is 80 per cent long and 20 per cent short. That is because an allocation to short selling is a certain loser over the long term and one to inflation-adjusted Treasuries is a certain winner.
Arne Alsin is a portfolio manager for Alsin Capital and for the Turnaround fund.