Riders on the Storm – Short Selling in Contrary Winds: Traits of Excellent Managers – 2006
The Need for Non-Correlation
One way to reduce risk is through diversification, but not in the customary sense of the word. The College of Financial Planning describes diversification as follows:
“Diversification and the reduction in unsystematic risk require that assets’ returns not be highly positively correlated. When there is a highly positive correlation, there is no risk reduction. When the returns are perfectly negatively correlated, risk is erased. This indicates that combining assets whose returns fluctuate in exactly opposite directions has the effect on the portfolio of completely erasing risk.”
Yet, we are facing systemic risks, which require that we go beyond the normal idea of diversification and find assets that have a highly negative correlation so that we might truly reduce risk. The slide below shows the positive correlation of traditional asset classes such as equities, international equities, and bonds and the varying degrees of correlation of non-traditional asset classes, noted with arrows.
In keeping with our desire, and for some our fiduciary responsibility, to seek assets that fluctuate in exactly opposite directions, let us turn from the crowd of long-only managers in the marketplace today to managers who are well positioned to help investors by using tools that are “perfectly negatively correlated” and address many of the systemic risks addressed in sections one through three.
The greatest degree of diversification is found in managers who can go inverse or opposite of the stock market, namely short sellers.
Yes. I know, “Short selling is un-American. It is done by rogues, thieves, and especially pessimists, who are, or course, the worst of the lot. It is a terrible, terrible thing and must be stopped in our lifetime. We should halt it, restrict it, or at the very least revile those who make it their vocation. These sentiments are sadly not imaginary or rare. Rather, they genuinely reflect much of the investing public’s view of short selling.”
The above comment, taken from the foreword of Dr. Fabozzi’s book, Short Selling: Strategies, Risks, and Rewards, makes it clear that many who have become specialists in short selling have often done so at the expense of public approval.
Section 4: Traits of Excellent Managers
Yet, if we can get beyond our biases and look at this group of managers that have learned to stand outside the crowd, we are likely to see the same traits we admire in those such as Warren Buffettt and John Templeton. These investment icons made it their career to stand outside of the crowd. In fact, one of John Templeton’s most oft quoted maxims is “Never Follow the Crowd.”
Speaking of the crowd, consider that according to Harry Strunk, developer of the Strunk Short Index, the only short-only index available today, there are only eight short selling managers listed through November 2005. 1 On the other hand, according to the Investment Company Institute, as of the end of July 2005, there were 7,929 mutual funds. Now, that is a crowd.
Yes, I am very familiar with the handful of companies in the mutual fund industry that offer inverse funds. However, since these funds comprise less than one percent of the industry, our crowd posit is still quite tenable.
Though we will address some of the mechanical and technical aspects of selling short, it will likely prove more useful to you, the investor, to concentrate on the common character traits of successful short sellers, again, many of which are the same traits displayed by our revered American investment icons.
Pattern 1 – Fierce Independence
In a relativistic world it is hard to accept a viewpoint that declares itself right and others necessarily wrong. So at fist glance these managers appear arrogant and close-minded to many. But are independent-minded managers a detriment to your long-term investment success or do they increase your odds of protecting and growing your capital?
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