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Emerging from the shadows

By Roger Montgomery

Emerging from the shadows

Buy low. Sell High. That's all there is too it, right? Well, not quite. You see there is an alternative strategy that not enough investors are taking advantage of. You could sell first and buy later at a lower price. As long as the selling is at a higher price than the buying, it doesn't matter which comes first, you’ll still make a profit. Selling at a high price first is called ‘short selling’ and recently it’s becoming a more prominent part of the portfolios of wealthy investors and their advisers.

Unsurprisingly, enquiries from financial planning groups for new long/short and market neutral funds, including ours, is increasing simply because the incumbent funds are fast filling up and closing their doors to new investors.

So why are these alternative strategies moving from the alternative investment background into the mainstream? The answer is simply high asset prices.

Low and negative interest rates have resigned many investors to the reality of very low returns. In a world of annual returns of just a couple of percent, unsophisticated investors' fears of missing out is fuelling bubbles in everything from so-called ‘stable’ stocks to art, to low digit license plates to property. These people believe low interest rates are here to stay.

Mark Twain's quote here is apt; "when you find yourself on the side of the majority, its time to pause and reflect".

Another band of investors are seeing the merit of pursuing strategies that not only have the ability to generate returns that aren’t dependent on the direction of markets but also offer the added protection that comes from an ability to generate profits in declining markets.

When Enron fell to zero, Jim Chanos from Kynikos made billions. David Einhorn's Greenlight Capital made billions for investors by 'shorting' Lehman Brothers. Andrew Left at Citron Research won plaudits when he correctly predicted Valeant Pharmaceuticals would fall, ultimately by more than 70% and Muddy Waters’ Carson Block made his investors a fortune when he unearthed and shorted a major business fraud at Sino-Forest.

Investors are wedded to the idea that there are signals and people that can correctly and repeatedly predict when the markets are about to crash. By pursuing such holy grails investors hope to be able to jump in and out of the stock market at the right times. But you don't need to.

History shows that investors tend to do the exact opposite of what works in investing; They tend to sell at the lows and buy at the highs.

Instead of an 'all-in' or 'all-out' approach, it is far more sensible – and simpler - to build a portfolio that includes investments that eschew the requirement to make prescient entry and exit decisions. By adding investments to your portfolio that profit from falling asset prices, you can ride through the inevitable storms and emerge protected as well as positioned to take advantage of the lower prices.

A 'fat tail' is an event or risk that is infrequent but will have a significant impact on returns. By allocating a small proportion of one’s portfolio to strategies that emerge unscathed, or even more valuable, through such events, the investor protects their portfolio.

Most investors know little about these strategies because most managers that run these funds, aren’t offering them through the most widely adopted platforms, wraps and approved product lists. It tends to be the very high net worth investor that benefits.

Personally, I have adopted this approach. I have invested in our global long/short fund and our market neutral fund. I have also opened an account that allows me to hold short positions in global bonds, believing that if global long-bond rates rise, I will make a profit to at least partially offset the losses such an event will have on the market value of my portfolio.

A market neutral fund buys a portfolio of high quality companies the fund manager believes will outperform an equally-sized portfolio of short sold, poorer-quality stocks.

If we assume the market falls 10%, the bought portfolio falls 9% and the short sold portfolio of poorer quality stocks falls 11%, the investor would have lost 9% on the bought portfolio but they would have made a profit of 11% on the short-sold portfolio. As a result, they made 2% even though the market fell 10%.

Of course, it could have gone the other way. If the market fell 10%, the bought stocks fell 11% and the short sold portfolio fell 9%, the investor would have lost 2%. But remember, even though a 2% loss is not ideal, the market fell 10%.

It doesn't matter if the market rises, falls or trades sideways. As long as the fund managers choice of purchased stocks beats the portfolio of short stocks, the investor in a market neutral fund will profit.

In a world of high asset prices, low or negative returns are likely to follow. Having some exposure to alternative funds makes a lot of sense. Unfortunately unless you pressure your adviser to investigate, most investors will miss out. And after 30 years of declining interest rates, now is the time to be thinking alternatively.

 
Roger Montgomery
Roger Montgomery

Roger shares his stock market insights at his Insights blog, blog.rogermontogmery.com. Investors can also follow Roger on Facebook and watch media interviews at his YouTube channel. Grab your Second Edition copy of Value.able and learn how Roger Montgomery values the best stocks and buys them for less than they're worth. Grab the book now at special price!