How to make money in falling markets

31 May 2019

When we think about making money from our investments, most of us imagine investing in the shares of companies that we like and that we expect will do well in the future – a natural assumption

We’re investing our money today, in the hope that the price of the shares will rise over time and, in doing so, will increase the value of our savings over the long term.

But it’s also possible to make money when the price of a share falls, by ‘shorting’ it.

In its simplest form, shorting is a way of expressing a negative view, rather than a positive one – for example, if you don’t like the outlook for a company or an industry, and think it will struggle in the future. A real-life example of this recently has been the high street; the outlook for shops has been poor as they have struggled to compete with online shopping businesses.

Shorting made simple

Let’s take a simple example: apples cost £1 each this week. I think the price will fall next week, but my brother thinks it will rise. So I borrow five apples from my mum’s fruit bowl and sell them to my brother for £5. The following week the price falls to 90p, so I buy five new apples for £4.50, put them back in my mum’s fruit bowl, and pocket the 50p profit.

The trouble is, you have to be right. If the price of apples had risen to £1.10, then I would have made a loss of 50p instead.

As there is no upper limit on how far a stock price may rise, losses can be very painful. This is why shorting has typically been the preserve of skilled professional investors and hedge-fund managers, who will also use a ‘stop loss’ to limit potential losses they could make.

I’d never suggest shorting is something an individual investor should consider doing themselves.

Shorting is also not limited to the shares of companies. Bonds, commodities or even whole stock markets can be shorted, for example.

Most professional investors will use specialist financial instruments, such as ‘contracts for difference’ (CFDs), to create ‘synthetic’ short positions, rather than borrowing physical assets (as we used in our example). It’s a similar process in that they enter a contract to sell a share and then buy it back on a specific date.

Finding short funds

A number of professional investors combine conventional long positions (investing in companies or assets they think will do well in the future) and short positions in their portfolios, with the aim of generating positive returns, regardless of market or economic conditions. The extent to which they do this differs from fund to fund.

Two funds that have shorting at the heart of their process are BlackRock UK Absolute Alpha and Jupiter Absolute Return. The BlackRock fund is a UK equity long/short fund, investing in UK businesses of all shapes and sizes, while the Jupiter fund invests globally. Jupiter’s manager, James Clunie, is something of a short selling specialist, having completed his PhD on the subject. The fund has a very low correlation to other assets – it doesn’t move in the same direction, so it can make a good diversification tool in a wider portfolio.

“Shorting expresses a negative view of a stock instead of a positive one”

Investec Cautious Managed is an example where shorting is used to a lesser extent and on a more tactical basis. Manager Alastair Mundy has a distinctive contrarian equity investment process, and combines it primarily with bonds, but also gold and cash. The intention is for the equity portion to drive the long-term performance, while the fixed income portion reduces volatility. Mr Mundy currently has a ‘short’ on the US stock market, which he believes to be overvalued.

BMO European Real Estate Securities fund is my final example. It invests mainly in property-related shares in the UK and Europe. The managers also short unfavoured stocks, which is a big positive given the small size of their investment universe, and it enables them to express a wider range of views.

Most funds of this ilk will charge a performance fee – but not all – and they are all very different. So if you are considering investing in one, it is important to research it very carefully and to make sure you understand what it is trying to do, before adding to your portfolio.

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius’s views are his own and do not constitute financial advice. The mention of specific securities is for illustration purposes only and not a recommendation to buy or sell.

Darius McDermott is managing director at Chelsea Financial Services and FundCalibre