Three Simple Short Plays During Market Volatility

After several years of a relatively benign environment for investors, 2015 is a reminder of how things can change very quickly.

Bonds, a one way bet for over a decade have, at times, become as volatile as equities. Equities, which for some time had been exhibiting a sustained level of low volatility, have reversed quickly. Commodities have simply continued their sustained downward trend.

As a trend investor, monitoring over 30 global equity, bond and commodity indices, we currently see only two positive trends in place: UK small and UK mid-caps – everything else is negative.

As unconstrained investors, such events in the past would have led us to simply sit in cash. Today we are able to take more positive action. Due to the extent of the declines, our investment process is telling us we should be shorting certain markets and the ETF product universe now provides for such an opportunity. For us, futures are cumbersome and don’t always target the area of the market that we require. This means that we can enter the realms previously reserved for hedge funds, but we can do so without recourse to involving much, if any, counterparty risk and through regulated vehicles.

Shorting UK Gilts

Our largest short position is in UK gilts, which peaked in March of this year and have delivered negative returns since. Many investors called this a “Great Rotation”, but they did so too early. As we simply follow trends, albeit in a sophisticated manner, we stayed with the gilt market through 2014 and it contributed greatly to our returns that year. However, now it appears to have turned over and we have taken action accordingly. We have done this via the db X-trackers II UK Gilts Short Daily UCITS ETF (ticker XUGS).

Now, the astute reader might start to mutter about the “compounding risk” of such a product. This is because it resets daily and therefore will miss the market return, and you do have to factor any cost of carry. However, if asked the question: “will it make money if the gilt market declines?” the answer is “yes” and to us this is better outcome than holding cash (yielding nothing). The reality is that the inverse db X-trackers index looks very like the gilt market, if you were short the latter:

db X-trackers Short gilt index vs FTSE All Gilt Index (inverted)

Source: Bloomberg

There is a swap involved in this product, but it’s limited to 5 percent and is over-collateralised by Deutsche Bank, the issuer, who also publish the makeup of this collateral.

Shorting The FTSE 100

Our next largest short position is the FTSE 100. Initially, it might seem odd that we should be doing this when we are long the mid and small cap indices. However, when one considers that the large cap index consists of many resource stocks and internationally exposed companies, versus the other indices’ bias towards the domestic economy, it’s not all that surprising. We get our exposure via the db X-trackers FTSE 100 Short Daily UCITS ETF (ticker XUKS). Again, one has to consider the compounding issues and cost of carry, but from a directional play point of view it meets the requirements.

Shorting Commodities

Our third short position is in the ETFS Daily Short All Commodities UCITS ETC (ticker SALL). It is a well documented fact that commodities have not been a beneficiary of the deflationary pressures that now persist in the world. Couple this with the Saudi desire to squeeze America’s shale industry by lowering the price of oil to such an extent that it makes production unprofitable and you end up with a tough environment for commodities. While all commodities supply usually marries up with demand in the long run, there’s every likelihood of a recovery, but from what levels? Meanwhile, we can use the ETF Securities fund to take advantage of the situation.

As a final note, we don’t seem to be alone in utilising these vehicles. Since March, the ETFS Daily Short All Commodities UCITS ETC has grown from $2 million to $10 million, the db X-trackers II UK Gilts Short Daily UCITS ETF from £10 million to £20 million and the db X-trackers FTSE 100 Short Daily UCITS ETF from £18 million to £30 million (source: Crossflow). So, clearly demand for products of this nature is growing, as investors decide to take positive action during this pickup in volatility.