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Short-selling involves borrowing securities, selling them on the open market and buying them back at a future date – ideally at a lower price.

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As the chorus of experts predicting a global recession grows and the equities bull market continues into its second decade, some financial advisors and investors are placing a greater importance on preparing portfolios for a bear market.

That could include several defensive measures, but one option is a short-selling strategy designed to make money when equities markets go down. Several asset-management companies offer mutual funds that take both long and short positions as an “alternative” asset class.

Reid Baker, director, analytics and data, at Toronto-based Fundata Canada Inc. says long/short funds are a good way for investors to get an added level of safety if markets go south.

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“If a portfolio is already well diversified, it’s worth having one of these alternative funds for an extra element of diversification,” he says, adding that the complicated nature of long/short funds require a certain level of sophistication from the investor.

“It’s important to know how and why one of these funds is going to diversify your portfolio and how and why the diversification benefits might fail.”

As the name implies, a long/short fund has two basic components: a portfolio of securities designed to benefit from a rise in value and a portfolio of securities designed to benefit from a drop in value. It’s up to the fund manager to offset the two components for a higher overall return.

Short-selling involves borrowing securities, selling them on the open market and buying them back at a future date – ideally at a lower price. A long/short fund manager can use the long side of the fund, which owns the securities, as leverage to borrow up to one third of the assets for the short side. The practice is called a 130-30 strategy.

“A fund manager is 100 per cent invested, sells short the bottom third of the assets and reinvests the proceeds from the sale into the top the of the portfolio. Essentially you have 130 per cent exposure long and 30 per cent short,” Mr. Baker says.

The success or failure of a long/short fund hinges on the quality of management perhaps more than any other asset class. For that reason, long/short fund managers don’t – and aren’t required to – release a great deal of information about the fund. In addition, strategies can change without notice.

“They don’t necessarily want to tell you exactly what they’re doing. They don’t allow competitors to see exactly what they’re doing. Their goal is to outperform the market and their competitors,” Mr. Baker says.

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Annual management fees for long/short funds are often in line with other mutual funds (2 to 3 per cent annually), but hefty performance fees are normally tagged on. Mr. Baker says it’s the price investors must pay for good management.

“It’s their full time job. It’s what they’re doing every day. They’re putting a lot of research into their methods,” he says.

Financial advisors and experienced investors who want to bypass the cost and secrecy of long/short funds can sell stocks short directly.

JJ Kinahan, chief market strategist at Chicago-based TD Ameritrade cautions that short-selling should only be done with a large investment portfolio, a good understanding of how short-selling works and a plan.

“You should be very well capitalized, understand the risk, understand the price where you’re going to take profit and – more importantly – what’s the price where you’re going to get out if it goes against you,” he says.

His advice for those with little short-selling experience is to wade in on the options market by buying puts or put spreads, which give investors the option to sell a security they expect will fall in price at a higher price within a specific time period.

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“If you do spreads, you can probably do it for significantly less money up front. I think one of the biggest things an investor has to be conscious of is limited capital,” Mr. Kinahan says.

Although the biggest risk to buying long – or even investing in a long/short fund – is losing all of the money invested, potential losses from short-selling are unlimited.

“If you go long a stock, it can only go to zero. If you short a stock, theoretically, the price can go up forever,” he says. “Sometimes you see a company get taken over by another company and it goes up by 40 per cent. That’s not the kind of loss a lot of people can withstand.”

To add risk to risk, the broker who loaned the stock being shorted has the right to demand they be returned at any time. The short-seller could be forced to buy the stock at a higher price – and even buying the stock could be difficult if it trades on low volume.

“It could be taken away from you very quickly and you may not be able to borrow it again. Then, you have to cover it in the open market and that often leads to losses,” Mr. Kinahan says. “You want to make sure you’re doing it in a stock that’s easy to borrow and very, very liquid.”

Short-sellers also incur a fee for borrowing a stock, which grows as long as the position is held. He says the interest rate depends on the investor’s relationship with the broker and is usually lower for more frequent traders.

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