Written by Callum Abbot

April, 2020

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Shorting away the risks

The key point of difference for JPM UK Equity Plus is its ability to short. In my previous two articles on the JPM UK Equity Plus fund, “Extending the alpha opportunity in UK equity” and “Standing out from the crowd in UK equity”  I explained how shorting gives us, as portfolio managers, both a differentiated potential alpha stream and a different risk profile to our peers, including a tool to manage a risk that is often associated to this technique, liquidity risk.

Macro risk

In a portfolio it is easy to build up correlated risks. For example, a manager may have high exposure to the UK consumer, or oil price or base metals. Long only funds have limited ability to manage these risks.

Take the general retail sector. A manager might be overweight Dunelm, JD Sports and Next, but if they hold all these stocks in size they will have exposure to the UK consumer. It is hard to offset that as even if they go underweight all the other general retail sector it is unlikely to be sufficient to reduce this risk.

Shorting not only gives a manager another alpha opportunity by shorting those general retailers he or she views as the weakest in the sector, but this is also a tool to reduce the funds risk, in this case by shorting away some of the exposure to the UK consumer. 

Size risk

In the UK, the average fund manager has around 45% of their fund in in small and mid-cap stocks compared to the FTSE All-Share index weight of around 20% (see Fig.1 below).

Figure 1 UK small & mid cap exposure

Many fund managers will say that small and mid-cap stocks are less efficiently priced due to sparser sell side coverage and so offer the most attractive opportunities for active managers. If you except that small and mid-caps are less efficiently priced then some must be overvalued as well as undervalued. It cannot be a one way bet and so there must be small and mid-cap stocks that are attractive to short.

As I mentioned in my previous article, in 2019, the 10 worst performing stocks in the FTSE All-Share were all small and mid-caps and of the 102 stocks that underperformed the benchmark by 20% or more, about 90% were small and mid-caps. We were able to short 8/10 of the worst performing stocks, which generated significant alpha for the fund, but it also helped reduce our small and mid-cap net exposure (this is only an example – as always, past results are not indicative of future results).

In JPM UK Equity Plus we have considerable gross exposure to small and mid-caps, including those we consider as inefficiently priced, but we go long those we like and short those we do not. The result is our net exposure to small and mid-caps is not meaningfully different to the benchmark. This gives the benefit of a differentiated source of potential alpha but also the benefit of targeting a reduction of our size risk.

For more information on shorting as a tool for alpha generation and how it can open up the UK equity market, please see our other articles on the UK Edge.

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