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Short seller

Short only? Little money is invested in the essential, diversifying and risk reducing strategy known as short only. It remains an obscure, controversial backwater despite plenty of capacity. It was inevitable performance would be good when so many "experts" said short selling didn't work anymore! If you are not short selling then you are not hedging. If you are not hedging then you have too much risk. While long positions are optional, short positions are mandatory.

Recently I've seen several fund of hedge fund presentations that proudly state they do not allocate to short biased strategies. I've even heard otherwise intelligent investors say they value what other hedge fund strategies can deliver but would never allocate to a specialist short seller because it would amount to a bet against their long only holdings! This reflects a disturbing misunderstanding of risk management and basic portfolio construction. Skilled fund managers bet against themselves all the time; it's called hedging. It's not optional, it is mandatory like car insurance.

Diversification means allocations that depend as little as possible to each other. Since most investors are long equities and bonds, they need complementary investments with the lowest risk factor covariance. Sadly many hedge funds have a positive correlation to some underlying risk factors. Managed futures CTAs and macro traders sometimes achieve slightly negative correlation but skilled short only managers almost always achieve very negative correlation often as good as -0.5 to -0.75. In simple terms, short only is the most reliable strategy to zig when other strategies zag.

Most people look at hedge fund performance on a stand alone basis which is incorrect - it is the blend of return sources that counts. A fund must be studied in the context of the investor's total portfolio. For risk reduction, negative correlation and diversification, short only funds are an ESSENTIAL portfolio component for ALL investors. Many investors make the disastrous mistake of ignoring short biased funds because long term absolute returns have not been good. The anomalous bull market of 1990s in USA/Europe meant short strategies swam against a strong upward current. Of course in Japan, short selling equity was by far the most lucrative investment strategy. I haven't BOUGHT a Japanese stock in many years but I continue to short SELL them.

Including short only in a total portfolio smooths volatility and reduces total risk, EVEN if the long term performance from the short only component itself is poor. Of course, you have to be careful benchmarking short only funds as you must invert everything. They did well in 2001/2002 but if the market loses 20% and they make 20%, all they have done is just match the index. However with most markets up this year, the returns are generally impressive from the few specialist short only managers. Their DIVERSIFYING role in a portfolio is invaluable.

So there you have it. A neglected strategy with VAST capacity and opportunities globally and where most of the current managers in the space actually have skill. Absolute returns, pure alpha, negative beta AND reduction of risk and volatility in the total portfolio! EVERY investor, especially conservative and risk averse ones, should have some of their money with short biased managers. Hedging is what a proper hedge fund is for. Contrary to Wall Street hype, many stocks go to zero over time.

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