Short selling - risky and difficult, controversial, but probably a key part of long term alpha
Short selling is certainly a difficult business, it is certainly controversial, and it is something that to date I have never done**... But I also think that it is a key part of long term alpha. I think that a significant chunk of outperformance by long-term successful hedgies is probably the result of generally successful short selling as part of a strategy. This does two things, first it helps cushion the blow of a substantial market drop, resulting in lower draw-downs. And second, it can put into your hands a big pile of cash at exactly the best possible time to have a pile of cash: right after a market drop.
(I have in real life shorted numerous levered ETFs, calls on the same, and so forth. And one time I shorted naked calls on LVS and that did work out for me, but only because my timing was super-lucky, as LVS has shot straight moonward over the last 1.75 years)
Therefore, I am going to spend some time pondering short selling, and probably considering applying it to my real life money management. For my own self-interest, mind, the fact of the matter is I am not a huge fan of short sellers, and in fact I find them annoying. Being bearish and negative seems to empower people with this sense of intellectual superiority, which is annoying. Short selling victories are heralded as strokes of epic genius in the press, which probably contributes to this, and is annoying. Short sellers frequently get on youtube, and TV, and anywhere else they can to slander the companies they want to short and try to build fear. Sometimes they even write books in an attempt to salvage a short gone bad. All annoying. And, most annoying of all by far, is that today, after a couple of significant bubbles and a decade in which short selling has certainly had some epic moments of glory, every other blogger on the internet is in a perpetual state of running around trying to find the next great bubble, which is extremely annoying. And they run around trying to explain their activities as altruistic and helpful, which is of course silly, as they are not in any way trying to make the world a better place, they are trying to make money. Silly is annoying, and so is dishonesty, I have no problem with them trying to make money.
Beyond being annoying... in all honesty I do not think that my mind is exactly wired ideally for short selling. I think my mind is best wired for spotting cheap stocks for long ideas, and perhaps, really, if I have a skill, its my willingness to bet against a massive mountain of negativity (being "all in" in march 09, july 09, and july 10). I do not expect that I will easily find myself a great short seller, and for a wide variety of reasons I will discuss below short selling is, frankly, a difficult business, and for those reasons I don't exactly plan on trying to make "the big short". If I could simply attain a bit of a hedge I would be satisfied, as to date I have (often badly) underperformed the market on every downturn. But, I have made up for this by grossly outperforming the market in the period just following the end of the downturn, presumably by doing a good job of picking stocks during the downturn.
Exhibit A: First, lets take a look at a couple of things that make short selling a difficult business:
1. In theory, your potential profit is far less than going long, and your potential loss far greater. You sell a share of AAPL short for $335, you can only make $335 if the stock goes to zero. There is no limit to how much you can lose. If AAPL goes to $11,970, you lose $11,635. You could, in theory, make more than $335 shorting AAPL to zero, if you increased thenumber of shares you were short as the price fell. But thats a bit of a seperate discussion.
2. It can, depending on how you do it, tie up a great deal of your capital due to margin requirements
3. While being long can frequently come with negative carrying costs, perhaps substantially negative (i.e., dividends), being short can come with significant carrying costs. These include the cost of borrowing shares (sometimes this can be big, sometimes low), the cost of paying dividends (if you are shorta stock that pays a dividend, you will have to pay the divi) and perhaps interest on a margin loan applied to being short, if applicable.
These are some significant difficulties that you have to contend with.
Exhibit B: To highlight these difficulties, lets take a look at a couple of real life short funds and how they have done. Its pretty scary
graph of the 10 year performance of Steve Leutholds Grizzly short fund. Leuthold is a fantastic fellow and fund manager, and one of my very favorite commentators on the markets. The Grizzly fund, I think, is a quant short, as in it shortsstocks according to a formula that they have contrived. They do not spend hours a day looking for shorts and thinking them over, but presumably the overall formulas were carefully crafted. But, GRZZX has grossly underperformed the inverse of the S&P over this time, indeed by about 70%!
Also scary is the performance of Comstock Funds. These guys are very smart, and have quite a track record of calling bearish events ahead of time. They called the onset of a massive secular bear market before the S&P even peaked in 2000, recessions, housing bubbles, deflationary panics and more. But, they are so deeply permabearish that they fall into basically every trap of permabears. Then the market was 1500 they said it was going way lower, maybe 50% lower, when it was 800 they said it could theoretically go to the 600s, when it hit the 600s they just stayed bearish. Now this is not a dedicated short fund I don't think, but as they are so incredibly bearish I tend to doubt they have alot of long positions, and I think, THINK, I read somewhere that they went all in bearish sometime in the 90s. They have underperformed the inverse of the S&P by 25 percent over the last 5 years . OVer the last 15 years they have lostmore than 80%. Since the market peak in 2000 they have lost 30%, despite the markets being well down over the same time and an epic array of shorting opportunities available including enron et al, the tech bubble, the housing bubble, and the 08 commodities bubble. Since the market peak in 07 they are down double digits.
These go to show that the difficulties of short selling are very real indeed. It takes a very talented person to win consistently at that game.
To summarize this first part:
A) the advantage of short selling is that, if done successfully, and well, it can increase alpha by reducing the drawdown in a portfolio during a market crash, and by providing you with cash to go long at exactly the time that you need it most: after a big market crash
B) the drawbacks are that it comes with various, and substnatial, headwinds that make succeeding at it over long periods of time exceptionally DIFFICULT. Indeed, the goal of the rest of this thread is to try to highlight ways, if possible, to minimize the pain of being short and to maximize the odds of doing it well.
I'll hit "post" now, and offer up the next set of thoughts on the first reply to this thread. Please don't reply til its up.