Short Funds Could be a Shortcut to Success

Funds that allow an investor to go short on the market are quite popular abroad. In India, their time has just come

By Pravin Palande

Published: May 10, 2010 06:38:05 AM IST

Updated: May 10, 2010 09:01:33 AM IST

Not everybody can short-sell. Maybe financial speculators like George Soros can. But many people feel that short selling is what separates the men from the boys in the financial market.

For some people, the present rich valuations in the stock market is a good opportunity to sell shares without actually owning them. In other words, this is the time to go short.

On the other hand, someone who has been buying mutual funds and has never looked at the concept of shorting the market is unlikely to think about such options.

But what if there was a retail product that would allow a retail investor to invest Rs. 1,000 and see the investment double when the market halves?

Short funds are typically exchange traded funds (ETFs) that allow retail investors to take positions in the market and give inverse returns to the market movement. “These types of products are more for the institutional investor than the retail investors even in developed markets. These products might lead to higher volatility. But at the same time, these products should be welcome in Indian markets as they will get in the best global practices and make our markets more mature”, says Nipun Mehta, executive director and head of private banking, Société Générale in India.

Investors use short funds or inverse funds when they feel that there is a clear possibility that markets are going to fall in the near future. The Indian retail investor has always been taught that money in the markets is to be made only in the long run by buying and holding stocks. These funds will give easy options to go short on the market for everyone who believe that the market will fall. This should ideally bring in more depth to the market but will also increase the downward volatility of the market.

Certain stocks are difficult to short in the Indian markets because of a dysfunctional borrowing and lending system. This problem can be resolved by short funds. Thus liquidity in the markets will go up.

Most investors prefer to invest into a short fund as they do not have to bother with mark-to-market calls that they will have to pay if they had used derivatives. In short, funds investors understand their downside potential loss. In derivatives, the same loss can be unlimited. But most importantly, Indians will be able to hedge their portfolios at very low costs in situations where investors have huge long positions and don’t know easy ways to protect their portfolios.

In the US, there are many investment houses that manage short funds; the most prominent amongst them are Proshares, Horizon Betapro and Direxion Funds that together manage $33 billion.

In India, the situation is the opposite.Few years ago, some Indian funds went to the regulators to seek permission to start short funds, but they were politely refused. They were told these products were meant for the sophisticated investor and Indian markets were not ready for it.

Short funds and leveraged short funds are very useful for hedging or lowering an exposure to a particular industry for a certain period of time at lower costs. It is about finetuning financial exposure by using simple techniques.

Critics argue that Indian investors are yet to get comfortable with even the regular “long-only” mutual funds, and feel that such kind of sophisticated funds will only give a bad name to the existing mutual funds if used by investors who don’t understand these products.

But the same argument was given for exchange-traded derivatives in early 2000. It was said that Indian investors will not understand these products. Today, India generates the highest turnover in single stock futures in the world. The same might just happen with short funds. One never knows.

(This story appears in the 21 May, 2010 issue of Forbes India. To visit our Archives, click here.)