Alpha generation in equity investing can come in various forms. Traditionally, active managers will hope to beat their benchmark by overweighting those stocks they think can outperform. But what about the flip side of that equation? Long-only managers can only express a negative view of a company they think will underperform by going underweight or excluding it altogether. However, with rising benchmark concentration in recent years, the impact of simply avoiding an underperforming stock has become increasingly marginal, aside from a few dominant names.
The S&P 500 illustrates this point well. The substantial concentration in the index’s largest stocks means that you only have to get to the 13th largest stock for it to equate to 1% of the index weighting.
The ability to short stocks, therefore, opens up another potential alpha avenue. We view shorting as a route to achieving meaningful underweight positions in unattractive stocks that may only be a small constituent of an index or off benchmark. It enables our portfolio managers to express negative conviction on a much greater number of stocks than long-only peers, and to engage in another route to alpha.
How we identify suitable short positions
With over two decades of experience managing long/ short equity strategies (since 2003), our specialist investment teams in our International Equities Group bring proven expertise. Our investment process combines quantitative screening of thousands of stocks with deep fundamental research, leveraging large teams of analysts, portfolio managers, and data scientists.
Our analysts focus on forecasting long-term earnings, and by comparing these forecasts to today’s share price, they calculate a long-term expected return for the companies we have under coverage. This numerical output represents the annualised 5-year expected return we anticipate from holding the stock.
We then take these expected returns, rank them highest to lowest in each global sector, and divide them into five quintiles (also called valuation quintiles). Quintile 1 consists of the top 20% of stocks that are considered the most attractive or undervalued within each sector, while quintile 5 is the bottom 20% of the least attractive or the most overvalued stocks. The bottom quintile provides our investors with a target universe for our shorting ideas.
Implementing our insights into investment strategies
J.P. Morgan Asset Management has a number of strategies that implement shorting. The range includes active-extension funds, which hold long positions of around 120-140% of assets and short exposure of 20%-40%. We also use shorting in our unconstrained absolute alpha funds, where net exposure ranges from -40% to +40% and gross exposure is up to 260%.
Active extension/Equity “Plus” strategies
Our active extension strategies are designed to generate extra alpha by taking smaller short positions in companies that our research indicates are likely to underperform. The strategy maintains 100% net exposure, meaning that for every $1 a client invests, they get $1.40-$1.80 of exposure to the portfolio managers’ insights, so their money is being made to work harder.
By utilising an active extension structure, the strategy can express negative conviction on a greater number of stocks than its long-only peers. This flexibility allows it to generate differentiated alpha.
Absolute return strategies
Our absolute return strategies provide exposure to our best long and short stock insights globally, powered by our global equity research. They take larger long and short positions, with the objective of maximising alpha generation in both up and down markets.
This approach means performance depends on stock selection rather than market direction, seeking to generate positive returns in both rising and falling markets. The result is a fund which aims to deliver consistent risk adjusted returns with a low correlation to equity and bond markets.
Conclusion
In today’s increasingly concentrated equity markets, traditional long-only approaches may limit the ability to generate meaningful alpha. By incorporating shorting strategies, investors can more effectively express negative convictions, manage risk, and access additional sources of portfolio outperformance. As market dynamics evolve, broadening the investment toolkit to include both long and short positions can offer valuable opportunities for enhancing returns.