One of the more common questions we receive is why we don’t take more short positions “so my account can make money in a bear market.” 

For those who don’t know, shorting involves selling stock and then buying it back at what one hopes is a lower price. When it works as planned, the investor profits the difference between the selling price and the lower buying price. Naked short selling means the investor borrows the stock that he sells short.

In the past, shorting was considered a speculative practice not suited for retirement accounts or conservative investors. But with the introduction of short mutual funds, the practice gained more widespread acceptance–especially as the companies that offered these funds advertised them as a means to make money when the markets go down.

Today there are short funds for many common index funds. In theory, these funds move exactly inverse of the index they short. In addition, many companies offer enhanced Beta short funds. I’ll explain that concept, but first let’s go back to the initial question.

As investment managers who practice active risk management, whenever we enter a position on a client’s behalf, we must consider the damage that can occur if we are wrong and the market does exactly the opposite of what we expect. So when market conditions deteriorate, our focus shifts from trying to make money to doing all we can to protect client assets.

We use a variety of tools to help us make decisions about when to buy or sell. Our trading systems are geared toward longer-term trends. We make no attempt to participate in short trends that might last only a few days. This helps us avoid dangerous whipsaw trades and helps reduce our overall risk exposure.

Even in a prolonged bear market like we are currently experiencing, many of the downward moves are sharp and severe, lasting only a few days. In other words, by the time our indicators signal us to take a short position, most of the damage would already be done. Taking a short-term short position at those times would put assets at risk of a market retracement with a limited potential reward.

Making the situation even more complicated is the fact that during periods of high market volatility, most short funds do not behave as advertised. Let’s go back to the topic of Beta and then I can explain specifically what I mean. In the investing world, Beta is a measure of volatility correlation. Usually, the S&P 500 is used as the benchmark for measurement. An investment that is perfectly correlated or inversely correlated to the S&P 500 would have a Beta of 1.0. An investment that had double the volatility of the S&P 500 would have a Beta of 2.0. 

The chart below shows the daily price movement of the Dow Jones Industrial Average (black line), compared to DOG, ProShares Short Dow 30, an ETF that shorts the Dow (gold line). This chart covers the period from October 2007 until March 31, 2009. This fund is promoted as having a Beta of 1.0. In other words, it should have a perfect inverse correlation with the Dow.

For the first year portrayed, that correlation is fairly true. But look what happens beginning in October 2008. The volatility of DOG suddenly becomes much greater than its benchmark index. I added the green and red arrows so you could see the difference in amplitude of between the two positions. All of a sudden the downward moves of DOG are four or five times as volatile as the corresponding upward moves on the Dow.

Notice also that for the period depicted in this chart, the Dow is down about 46%, while DOG is up only about 35%. That is an 11% spread on two positions that should have a 1-to-1 correlated return. At times this fund is falling or rising by double digits in a single session–much more than the index it is supposed to be mirroring.

Because these short funds do not behave as they should, it makes it very risky to use them. We sometimes will take a position in a short fund, but it is usually with only a small portion of the assets. We also sometimes use short funds to hedge a long position that we do not want to sell.

Next week we only have four trading days because the markets are closed on Good Friday. We should get a good indication over the next few days if the current rally will have enough strength to continue or if another downturn is coming.
F.S.

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