We all know that bulls make money and pigs get slaughtered. But bears make money too. The question often faced by financial advisors is whether they should join them.
As a rule, the trajectory of the market is upwards over time. Those who buy and hold long enough will inevitably make money as the economy grows. Amen to that.
Nevertheless, that profitable ride from lower left to upper right on your computer screen — as beneficial as it may be over the long term — is also never, ever smooth. It contains dips, both big and small, that are designed to send even the most risk averse investors to the relative safety of bonds, cash or their mattresses.
All that said, those market potholes can be profitable for those who time the market correctly. While often discouraged as un-American, selling high and buying low is still a valid recipe for making money. It just takes great care because the losses can be infinite, which is why most financial advisors are loathe to do it in the first place.
“When clients ask about shorting stocks, I let them know how it works, the cost on margin and that it needs to be closely monitored to be closed before it runs away from them. Frankly, in most cases I would suggest that they just sell or avoid the stock versus shorting it,” said Scott Bishop, managing director at Presidio Wealth Partners.
Bishop does at times employ inverse ETFs, which rise in value when the market drops. However, he does it primarily to protect clients from a major tax hits if they have large, low-cost holdings in the S&P 500 and are seeking to create liquidity.
“Many times the inverse ETF works well for a day or short-term trade, but it may not work perfectly for long-term holds due to roll risk when the underlying futures have to be rolled. And that gets even worse if you use a leveraged ETF,” Bishop said, adding that buying put options on the stock or index may be the better and cheaper hedge.
Chris Mankoff, certified financial planner with JTL Wealth Planners, doesn’t recommend shorting stocks or using inverse ETFs because of several factors, including the complexity of leveraged ETFs and the unlimited loss potential from a short position, as well as potential margin calls, borrowing costs and timing risk associated with short selling.
If a client asks him about shorting the market, Mankoff responds by engaging them in a deep conversation about the reasons behind their bearish outlook.
“I take a long-term investment approach, so my response may not fit someone’s bearish narrative. I would simply rather not own a specific stock or have specific equity exposure versus betting against the market,” he said.
Along similar lines, Matt Chancey, certified financial planner with Micel Financial, doesn’t recommend that clients short stocks. In his view, the concept of betting on the downside is far too risky because in theory the amount of loss is unlimited.
That being said, Chancey has purchased put options on companies he believes will go down.
“Buying a put lets me limit my risk,” he said. “The other part I like is it also makes me define the time frame that I think the loss will occur since options have time decay and don’t last forever. That way you have a direction, down, and a time frame when you think that will occur.”
Ted Haley, financial planner with Advanced Wealth Management, is among the advisors who refuse to short stocks and recommend inverse ETFs. When clients feel bearish, Haley tries to bring them back to their long-term plans, which should be built to account for the inevitable ups and downs of the market.
“No matter how much conviction we have in where things are heading, it is highly unlikely that we will time things correctly consistently. Even if we were to have a crystal ball that showed us what would happen in the world, we would probably incorrectly guess the markets’ reactions. The pandemic was a perfect example of that,” Haley said.
TO HDGE OR NOT TO HDGE
Brad Lamensdorf, co-portfolio manager of the Ranger Equity Bear ETF (HDGE), said that there are generally two ways investors use his bearish fund, which is down almost 16% year to date, but up almost 11% in the past month. Lamensdorf’s ETF is predominantly short 50 to 70 forensically selected names with a technical overlay.
“We have one group of shorts that uses this when the indexes fall below the 200-day moving average and when it goes above the 200-day, they cover,” he said. “Other managers may have a blended 20 or 30 different positions inside of an asset allocation, and we are a 3% to 5% sliver of that entire allocation.”
As to why anxious investors would rather take the additional risk of betting against stocks instead of simply buying bonds now that they’re offering truly attractive yields, Lamensdorf, like Bishop, said it’s not all offense. It may also be a function of having a tax position they are trying to protect.
“Maybe they own Microsoft at $10 and they don’t want to just sell it,” he said. “But they’re constrained, extremely worried about a market decline. So this is a great way to layer on some protection against that decline that you would be expecting.”
Still, the majority of financial advisors simply prefer not to make money by shorting stocks.
“I personally have never recommended a client to short stocks, our firm doesn’t like taking bets on the market and prefers a buy-and-hold approach that historically has shown to produce better long-term results,” said Andrew Fincher, financial advisor with VLP Financial Advisors.
Amen to that, too.