Advantages and disadvantages of short selling

Short selling is the act of borrowing stock and selling it in the market in the expectation that the price of the stock will decline, before buying the stock back (hopefully at a lower price) and returning the stock to the lender. The borrower pays the lender a fee for this service, typically a margin above a risk-free interest rate.

For a ‘long-only’ portfolio the manager is limited to holding positions deemed favourable and under-weighting or having no weight in positions deemed unfavourable. Including short selling broadens the potential opportunity set for a manager to take both positive and negative views on stocks with the expectation that this will lead to additional return.

We find meaningful returns can be derived from shorting stocks, although the process does carry potentially greater risk.

The advantages of short selling include:

There are, however, issues with short selling that need careful consideration:

There is also the view that short selling works against the interest of ‘long’ investors. While we would prefer to not to get into the merits of short selling, as an investment option it can provide meaningful excess alpha to a portfolio’s returns.

At Equus Point Capital our risk management process recognises the potential pitfalls around shorting stocks by:

DOWNLOAD PDF