The UK equity market can’t be fully exploited for returns without the ability to take short positions in a portfolio, according to James Illsley.
The manager, who runs the newly-launched JPM Equity Plus fund, has a 100 per cent net market exposure through using active extension, placing it in the IA UK All Companies sector alongside its long-only peers that are benchmarked against the FTSE All Share index.
The reason that Illsley believes short positions in the UK market are fundamental is that there are 645 stocks in the All Share but, because of how dominant mega-caps are, only 22 companies constitute more than 1 per cent of the index.
“Because of this large portion of mega-caps, you’ve got this long tail of relatively small stocks. What that means is, if you don’t like a stock, all you can do in a long-only fund is not own it, whereas with a little bit of shorting we can increase our underweight exposure to the stock by taking that short position,” he explained.
“Even a big company like Pearson, for instance, is only 35 basis points of the index. So if we don’t like Pearson in a long-only we can’t own it, and the stock falls 30 per cent over six months, we would make 10 basis points or something, which wouldn’t be a material contribution to performance.”
Funds with the ability to short, most of which sit in the IA Targeted Absolute Return sector, are becoming increasingly popular among UK investors following the high levels of volatility we have seen in the market so far this year.
Global headwinds including the plummeting price of commodities, a slowing growth environment and a mass sell-off in the Chinese stock market have led to greater levels of caution among investors.
Managers of long/short equity funds argue that this volatility can be positive, as shorting positions during market turbulence can generate strong returns and keep performance steady during market downswings.
Performance of fund versus sector and index in 2015
Source: FE Analytics
In fact FE data shows that the best performing UK-equity related fund in 2015 has been the long/short City Financial Absolute Equity fund, which despite being a member of the absolute return sector, has beaten every IA UK All Companies funds year to date with gains of 22.22 per cent.
Luke Newman, co-manager of the Henderson UK Absolute Return fund, says that stock-picking long/short funds have truly come into their own this year following market turbulence, and have proven their usefulness during difficult times.
“For most of this year we’ve seen the market down in absolute terms and yet we’ve consistently been delivering a positive absolute return for our investors. It’s that flexibility not just to identify attractive names on the long side, but, particularly in those market sell-offs like June and August, to be flexible enough to identify where the money-making opportunities are in the big sell-offs as well,” he explained.
While the ability to generate returns regardless of market performance is a primary reason that investors hold long/short funds, Apollo’s Ryan Hughes argues that returns in excess of the benchmark can also be achieved through long-only funds.
“Shorting is a very difficult skill to consistently get right. Even the best long/short managers will generate the majority of their returns from getting their long positions right,” Hughes explained.
“Shorting is almost always a stock-specific issue and very much focused around the report and accounts of a company so it suits those managers who like to forensically analyse company accounts.”
“However, it should be remembered that there are plenty of opportunities to generate alpha in long positions and many of the most successful managers have only ever used long positions. Shorting is a specialised skill that only suits a handful of managers but when used well can be a great addition to a portfolio.”
According to the latest data from the Investment Association, which covers information from September this year, the IA Targeted Absolute Return sector saw the second-biggest net retail sales at £323m.
The top-selling sector was IA UK Equity Income, which suggests that investors don’t feel as comfortable relying simply on positive growth as a means of generating returns.
Performance of sectors in 2015
Source: FE Analytics
“If you’re long-only, you’re limited in being able to exploit any negative views. With shorting, you can properly exploit that negative view, and a lot of investors aren’t exactly feeling positive at the moment,” Illsley said.
“For us, if we don’t short, we’re going to be leaving some available alpha on the table. Traditional long-only fund managers tend to have lots of different ways of selecting stocks, but a lot of traditional long-only fund managers focus on 30, 40 or 50 stocks they want in their portfolio and don’t spend as much time looking at the bad stocks.”
One counter-argument some investors have for holding long/short funds though, is that while shorting can be useful it could also be dangerous if used badly. If there is a sharp period of mean reversion, for instance, funds could end up making substantial losses.
Meera Hearnden, senior investment manager at Parmenion, says that she doesn’t generally buy equity funds that short as the risks, when things do go wrong, can be compounded and are difficult to measure.
“As we manage portfolios within disciplined risk and volatility boundaries, the unquantifiable risks of shorting make it difficult to assess how badly something can go wrong in a portfolio, particularly when we have a duty to manage client expectations,” she said.
“Clearly, the opposite is true as well. If the shorts work out, then this can help dampen volatility and insulate some capital, but the problem is identifying managers that are consistently good at shorting. While we would not rule it out completely, we would prefer to find managers that can add value in this way consistently.”
Despite Illsley’s short time frame running JPM UK Equity Plus, he has run long/short funds for many years and, according to data from JPM, the stocks he has picked to outperform over his track record have done so by 11 per cent on average per annum.
The stocks he has shorted over the same time frame have underperformed by 13 per cent.
“Our investment process looks at all the stocks equally, and that’s why we’ve got this balance between the good stocks and the bad stocks and our ability to discern between those two types,” he added.
Performance of fund vs sector since launch
Source: FE Analytics
Since its launch in September, JPM UK Equity Plus has returned 0.5 per cent, outperforming its peer average in the IA UK All Companies sector in the process.
