A handful of Canadian mutual funds with special regulatory permission to use short-selling techniques are finding little use for the potentially powerful tool in today’s hot markets. But they are nevertheless happy to have it in reserve for the day when cooler markets prevail.

“It’s comforting to have the tool in our back pocket, but we haven’t been doing much shorting,” says Peter Anderson, president of Toronto-based CI Mutual Funds Inc. “Right now, we’re seeing a lot more opportunities on the long side.”

Until recently, short-selling has primarily been the domain of hedge funds catering to high net-worth individuals, who must put up a significant stake just to get into the funds. But with CI, Dynamic Mutual Funds Ltd., Accumulus Management Ltd. and National Bank of Canada having received permission to use the short-selling technique in some of their regular mutual funds more than a year ago, ordinary small investors can now gain some short exposure.

CI applied in July 2004 for permission to use short-selling in 14 of its mutual funds, and received the nod from regulators in September 2004. This past October, CI received permission to go up to 10% short in all funds, although, Anderson says, not all CI fund managers want to employ the technique.

Shorting, which involves selling borrowed stock in the hope that the stock can be bought back at a lower price later on, is not simply a matter of doing the opposite of what a long manager does, Anderson says. Some managers would rather concentrate on “long” investments, which have the potential to increase in value. Short-selling is fraught with complex decisions on timing and market mood that may be less of a consideration when looking for companies that will increase in value with time.

“Short-selling is difficult to do,” says Mark Chow, an analyst with Toronto-based Morningstar Canada. “It’s not just a matter of finding a company in trouble; it has a lot do with measuring investor sentiment. There’s limited upside in shorting, and unlimited downside.”

Regulators have imposed tight controls on prospectus-sold mutual funds seeking to employ short-selling strategies, however. Mutual funds are far more restricted than hedge funds that are sold by offering memorandum and which can operate more freely. Fund companies must limit the losses on any short sale with a stop-loss order that kicks in if the price of the security rises to 115% of the price at which it was sold short. The market value of shorted securities is limited to 10% of the fund’s assets and 2% of fund assets for any single stock. Funds must hold a cash cover equal to 150% of the value of all securities held short, and may short only highly liquid securities.

The restrictions save investors from the unlimited potential losses that regular short-sellers are exposed to by the fact that a stock they have shorted could conceivably rise to unlimited heights before the position is covered.

Although the rules are designed to protect investors, Ross Healey, chairman of Toronto-based Strategy Analysis Corp. and manager of Accumulus Talisman Fund, has found the stop-loss restriction mentioned earlier to be potentially problematic. It forces the manager to close out a position if there is a brief rally during a prevailing downtrend for the stock.

“Short-selling is an awfully good idea, but the regulators have put so many controls on it that we have not found it particularly useful,” Healey says. “We took a couple of runs at it and discovered we were on too tight a rein. As it turns out, a couple of our positions that were stopped out would have done quite well if they’d been allowed to run. As a consequence, we’re now a bit gun-shy about using the technique and haven’t found it to be a particularly useful weapon, although that might change nicely in a serious bear market.”

For example, Healey took a crack at selling short a U.S. homebuilder when it appeared the real estate market was topping out. The stock broke down, then had a little rally back upward.

“The automatic stop bumped us out,” Healey says. “The next day there was an announcement about slowing home sales and the stock went right back down again. But we had been forced to lock in a loss. The experience has been less than scintillating. You can be dead right and still dead. You have to be lucky and not get caught in a random pop.”

@page_break@Although Healey got his fingers burned with the stringent rules, he is nevertheless happy to have the short-selling technique at his disposal and can foresee using it in bear markets. Regardless of the problems, Accumulus Talisman Fund achieved a one-year return as of Oct. 31 of 22.8%, beating the S&P/TSX composite index’s gain of 19.1%.

“We will not sell short as readily as we might because of the tight restrictions,” Healey says. “But in a genuine bear market, it’s a tool I would want at my disposal.”

Dynamic received permission in the spring of 2004 to use limited short-selling in its seven Dynamic Power Funds, but so far has been keeping its powder dry.

“We value the tool, and think there will be an opportunity to use it. But, so far, we have seen greater opportunities on the long side,” says Dynamic spokesman Trevor Hampden.

Funds classified by Morningstar Canada in the “alternative strategies” category have lagged during the past year. These funds use a variety of alternative strategies, including hedging and shorting. Morningstar Canada’s research shows the category gained 7.7% on average for the year ended Nov. 30, lagging the average Canadian equity fund’s gain of 16.1% and the average global fund’s gain of 8.3%.

“Any manager who shorted high-flying energy stocks in Canada during the past year would have been wrong, and perhaps out of a job,” says Dan Hallett, president of Windsor-based research firm Dan Hallett & Associates Inc. “It’s hard to tell if the ability to go short has added any value to these funds at this point.”

Jim McGovern, president of Arrow Hedge Partners Inc. in Toronto, expects the short-selling tool to be more useful in a flat or down market, when traders are more interested in the merits of individual stocks rather than the overriding trend. “It hasn’t been a good year for shorting,” McGovern says. “In a bull market, all birds fly — even the turkeys. The spread between good and bad companies will widen in a tougher market.”

McGovern says there have been more opportunities to make profitable short sales in the U.S. stock markets, which have been struggling this year to make gains in the face of rising interest rates. “It’s been easier to separate the wheat from the chaff in the U.S., and the falling U.S. currency has given a further boost to Canadian investors,” he says.

In addition to the 10% shorting privilege, CI will be making use of another alternative strategy in its Select International and Select U.S. Equity Managed Corporate Class funds to be launched in January. The funds will use derivatives to hedge 50% of their assets against currency fluctuations. The goal is to reduce the impact of exchange rate moves and thereby reduce risk in the two funds, which will invest mostly outside of Canada. However, if the loonie weakens, the half-hedged funds will benefit to a lesser degree than other global funds with no currency hedge.

“One of the big issues for investors going outside of Canada in the past few years has been the drag on global returns caused by a rising Canadian dollar,” Anderson says. “We are adding a component of protection against currency fluctuations.” IE