Shorts balance the long pressures. Long and short isn’t a conflict but as essential an aspect of investing, like in trading. More, why should investing be long only, while trading is both long and short and long-short? Human beings are predisposed to long only, because it’s an emotional thing. Long only is growth, we bet more on growth than on decay. Betting on decay seems fearful, not positive. Hence, it's harder to justify, comprehend a short-only view or perspective, build a short index. However, the reality is a lot different. We would like to believe there is more growth and less decay, hence, long only. This is why the behavioural endowment theory. We own things, we get biased and hence poorer decision making.
A trader’s life is different. He trades both ways, and is always close to the short idea. Even arbitrageurs understand short better, as they may look at exchange-traded funds (ETF) pair models, short coffee, long zinc. Many of our indexing models go cash, which again is an acceptance that it's not always about growth; outperformance (long) goes hand in hand with underperformance (short).
So, how do the short ETFs work? For any up-move on the asset value there is an equivalent drop in the short index value and vice versa. The underlying index is up 10 per cent, the short ETF on the underlying is down 10 per cent or vice versa. It was a novel idea to introduce a non-leveraged paper for shorting. This was a product innovation. While there is an advantage that the loss with such instruments is limited to the loss of purchase price, the fact that ETFs have to maintain a fixed leverage ratio leads to compounding error. Put simply, a short ETF may not mirror a short position. This creates problems for anyone using short ETFs for a complete hedge. So, though there is a convenience the respective hedge instrument has a poor design. A short index would solve this problem, as ETFs based on short indices will mirror the short benchmark perfectly. Currently, the short indices industry is non-existent.
So, how do we create a short index innovation? One way is to invert the existing long index (Dow 30), which as we see is psychologically not attractive in a secular uptrend, as investors don't want to bet on decay and into illiquidity. The inverted short index would work more like a volatility index, flaring occasionally and stagnating the rest of the time.
An ideal short index should be one that understands decay and can offer a timing tool to the investing community, going cash when the markets are in a secular total-up move, while selecting underperformers out of the universe and capturing alpha as underperformers fall, stagnate and decay.
A successful and popular short index has to work both ways, both in an active and passive style. The absolute active return index should have an ability to control drawdowns, conserve capital and deliver. But how do you discover alpha in a bull market while shorting? It's like asking are there short opportunities that exist in an up-trending market? Yes. And, they are spread temporally (across time frames). There are stocks in the S&P500 that are underperforming (falling) by more than e.g. 10 per cent quarterly, while the markets are outperforming (rising). Is it possible to find such opportunities for different holding periods? It's not a hard question for a trader, but what we are talking about here is a portfolio approach to shorting opportunities which can be called a short index.
This is where the next stage of short innovation begins. Building short indices for different rebalancing periods starting 30, 60, 90, 180 days, etc. What would these indices do? They become proxies for hedging for different periods for different universes. So, any investor who wants to hedge looks at his cost at any given point of time for a certain universe.
The short active and passive indices also address the potential wall of worry heading ahead of us in 2016-2017. Hedging as a science needs to evolve and we never needed it as much as we need it now. Along with this, we need the sleeping financial tigers like India to wake up and catch up. The Indian passive market is potentially a $100 billion market, a far cry from where we are today.
The author is CMT, and Founder, Orpheus Risk Management Indices, an Indexing company based out of UK
