The long and short of shorting

Do short positions belong in a portfolio's long-term strategy?

Paul Kaplan 17 September, 2012 | 1:00PM Christian Charest
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Christian Charest: I am here with Dr. Paul Kaplan, who is Director of Research here at Morningstar Canada, and today we're talking about short selling. Or more specifically do short positions belong in an investor's long-term asset allocation or should it be restricted to short-term bets or even avoided all together? Paul, what's your take on this?

Paul Kaplan: My take on this is that if you're a long-term asset allocation investor, you're trying to meet financial goals over a long period of time. The thing that you need to be concerned about is how does your money grow over time? And this is really the problem with using short positions or leverage positions or inverse positions. And that as once you do this, you have the – you're taking these short positions and the problem is that if you take too big of a short position, you can actually be completely wiped out of your capital if the market moves against you.

Charest: There have been a lot of tools that were introduced in the market over the past several years, exchange-traded funds that offer leverage exposure or inverse leverage exposure to indexes or commodities. These are basically forms of leverage. They are not as risky as owning an outright short position, but they do have some risks as well. They have been popular tools with institutional investors, but they can also seem attractive to individuals who may be tempted by twice the return. So, do you think these tools should be used by individual investors?

Kaplan: Not for those who are going to be holding their portfolios for any period longer than a day. The reason I say that is because those leverage in inverse products, what they do is they rebalance on a daily basis back to those positions, and what happens is when you do that there is a compounding effect. So that – if the more volatile, the underlying position is, or the underlying stock index, that now – the volatility gets multiplied by these strategies and that actually becomes what we call a volatility drag on the long-term performance. And so for example the stock, underlying stock index could be rising, but it may be rising in a way that's highly volatile; up and down and up and down and up and down, ultimately it reaches a higher point that when you started. But all those ups and downs are actually going to become a drag on let's say a two times or three times leverage portfolio.

So, if you'd simply held exposure to that index in a long-only fashion, you would actually – you would have made money – but if you held it in a levered fashion, you may have actually lost money when the underlying was growing.

Charest: Now, the fund companies that market these products have done a decent job of warning investors about the risks of the volatility drag, as you just explained. So, with all this, do you believe that there are individual investors, sophisticated investors, for whom these tools would be appropriate?

Kaplan: The only ones that I can think of that these would be appropriate for would be for day traders. I mean, these would be people who get up every morning, they place their bets and they close out their bets at the end of the day. So, I can see if they want to take, for example, take a bet against a particular index --maybe they can use the inverse ETF as a tool for doing that instead of just taking an outright short position.

Charest: That strategy goes with the intent and purpose of the one day rebalancing of those funds?

Kaplan: That's right.

Charest: Now, getting back to the short selling as part of the asset allocation. So, do you think there – you don't think it should be part of the investors?

Kaplan: No. I don't think a permanent short position belongs in an asset allocation. Furthermore, I would also warn investors against another type of product that uses shorting and leverage to try to in an attempt to achieve higher returns. What they tend to do is they take bets which over the long run in a long only portfolio would only give you a very small amount of risk premium. So, what they do is they expand, they expand on that by leveraging those positions up and basically you end up with the same problem which is the market moves against you and those highly levered positions become extremely risky.

Charest: So, it's a different form of risk from that traditional long-only portfolio?

Kaplan: Yes.

Charest: We actually have an article, which there is a link to right under the video player, which explains in more detail what the risk parity approach is.

Kaplan: Yeah.

Charest: Thank you very much for all this Paul.

Kaplan: Thank you.

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Paul Kaplan

Paul Kaplan  Paul Kaplan is Director of Research for Morningstar Canada.

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