Although several fund companies have regulatory permission to employ short-selling in their mutual funds, except for mortgage and money market funds, many fund managers are using the technique sparingly.

Short-selling can be a powerful weapon in protecting fund portfolios against bear markets. But fund managers are only too aware that if the market goes higher, short positions can create painful losses and burn investors.

“My sense is there is not a whole lot of hedging going on, although it’s difficult to gauge how much the ability to go short has been taken advantage of,” says fund analyst Dan Hallett, president of Windsor-based Dan Hallett & Associates Inc. “Shorting is a different skill than investing on a long basis — and it’s difficult to do well. If you’re shorting, you have to be right not only on the direction of the security but on the timing, and you can go broke waiting to be proven right.”

Several fund companies, including Dynamic Mutual Funds Ltd., Front Street Capital, CI Investments Inc. and Sprott Asset Management Inc. (all based in Toronto), have received special exemptions that allow them to sell securities short to a limited extent in some or all of their regular mutual funds.

Hallett says that even if a fund manager is ultimately right on a short position, he or she can be “bled dry” by having to put up the cash required for additional margin if the shorted stock moves up in the short term. And stock markets are notoriously difficult to predict.

During the three months ended July 31, Sprott’s regular mutual funds showed positive returns as they rode a strongly rising market. But Sprott’s family of hedge funds, which make more extensive use of short-selling techniques, lost value.

Peter Hodson, senior portfolio manager with Sprott and lead manager of Sprott Growth Fund, says he has made some use of the 20% short-selling allowance in his mutual fund, which is not a full-fledged hedge fund. For example, Sprott Growth Fund did well by being short on Teck Cominco Ltd. during the past year, and covered the position before it turned around and went the other way.

“Shorting is another tool, and it’s useful,” Hodson says. “It works best if a company is a terminal short, which means it’s going bankrupt, or if the company is extremely overvalued. But finding a terminal short is as hard as finding the next great thing.”

Hodson says that when oil prices were declining last fall, it made more sense to short his large-cap oil companies and benefit from the commodity’s price decline than to sell his illiquid junior oils at depressed prices. He believes that as a result of shorting, Sprott Growth Fund’s performance during the past year has been “marginally better” than it otherwise would have been. For the year ended July 31, Sprott Growth Fund lost 46%.

Hodson was recently holding no short positions because of a shift in market psychology toward the positive. Investors have been heartened by massive government monetary stimuli and, for the moment, they have decided the worst is over, he says. But, he adds, bullish sentiment could change quickly to bearish if the economic performance is disappointing.

“When you are short, there is a lot more to worry about. And the emotional pressure that can occur when the stock moves the wrong way can be nerve-racking,” Hodson says. “You need the temperament for it — you have to be able to control your emotions if the stock moves against you.”

Norm Lamarche, senior portfolio manager with Front Street Capital, says the ability to go short in Front Street funds — including Special Opportunities, Growth and Canadian Equity funds — was useful during the past year. But, he says, “At the end of the day, the portfolio was overwhelmed by the big downward move in the market.”

After a strong summer rebound, Special Opportunities showed a 13.5% loss for the 12 months ended July 31, while Canadian Equity lost 14.8% and Growth lost 28.8%. In comparison, the S&P/TSX composite index fell by 21.6% during the same period.

Lamarche continues to be 12% to 15% short in his portfolios as a defensive stance to strengthen the risk/return ratio and to smooth volatility.

For example, there are a couple of natural gas stocks he likes, but he is bearish on the commodity price for gas in the short term and is using futures to short the commodity. Often, when Lamarche is bearish on a commodity, he shorts the major companies that produce it or the related subindex, while going long on a few companies with growth potential.

@page_break@“We can eliminate the commodity move, and capture the growth alone,” he says. “Shorting gives you the opportunity to take advantage of conditions or accentuate certain moves.”

When Lamarche looks at a company or attends a corporate presentation, he ponders not only whether he likes a company enough to buy it but whether he dislikes it enough to short it: “Most managers are positively conditioned to look for opportunities to buy. The same information can lead to a different strategy with short-selling. It’s something you need to set your mind to — it’s not natural — but there is room for it in the overall portfolio approach.”

In the high net-worth space, Toronto-based Franklin Templeton Investment Corp. ’s Tapestry portfolios include an alternative strategy component for diversification purposes that includes short-selling. The allocation is set at 15%, but can be increased or decreased by five percentage points. The alternative strategy asset class is not correlated to other asset classes and, therefore, should result in lower volatility and higher returns overall.

However, the strategy didn’t distinguish itself in 2008, with the alternative asset class dropping by about 20% during the year, says Stephen Lingard, vice president and director of research with Franklin Templeton Managed Investment Solutions. It also didn’t help that the portfolios were hedged against exchange rate moves, at a time when the Canadian dollar was weakening.

“The strategy didn’t add significant value, compared with portfolios that were invested more heavily in fixed-income,” Lingard says. “For Canadian investors, the best hedge last year turned out to be U.S. government bonds, which benefited from a flight to safety as well as a 20% drop in the Canadian dollar against the U.S. currency.”

Assets that went into Tapestry’s alternative strategies came from both the fixed-income and equity components of the portfolios. Although it was beneficial to reduce exposure to equities last year, it was not an ideal time to reduce bonds, Lingard says, and the alternative strategy exposure was “a bit of a wash.”

Nevertheless, Franklin Temple-ton remains committed to the alternative strategy asset class. “There are a lot of strategies that a ‘long’ manager simply can’t implement,” Lingard says. “Alternative asset class managers add specialized expertise to the mix.”

Managers of regular mutual funds are not able to short-sell as freely as managers of hedge funds, which are regulated less. For example, even with special regulatory exemptions, the short component in regular mutual funds cannot exceed 20% of fund assets under management, and no single position can exceed 5%.

Stocks sold short must be liquid, listed on an exchange and exceed $100 million in market capitalization. The fund must maintain a “cash cover” of 150% of the total value of its short position to ensure the fund is not overleveraged, and must use “stop-loss” orders to close out short positions if the trading price exceeds 120% of the price at which the stock was sold short.

“We are generally in favour of managers having the flexibility to express their views within their portfolios,” says Al Kellett, a fund analyst with Morningstar Canada in Toronto. “The ability to go short to a limited extent is a positive development for fund unitholders. In a typical fund, managers who are really bearish have their hands tied and can only go to zero in a company — which, on an absolute basis, is not expressing an opinion. Those managers with the ability to sell short have the freedom to express their ideas and benefit from a bearish environment.”

IE