Query: I’m new to “shorting” thing in mutual funds like SIFs. Frankly, it’s a bit confusing.

What exactly is shorting, and how does it work in these funds?

Why do they bet on stocks falling instead of just picking good ones?

Is it risky, and could I lose a lot? How do fund managers choose which stocks to short, and what if they’re wrong?

Does shorting cost extra? Can it really protect my money in a market crash, or is it just a marketting gimmic to sell the SIFs?

Why havent heard about the use of shorting in all these years we’ve been doing SIPS? Is shorting really helpful? Should a small investor like me even try SIFs, or are they too complex?

Answer:

Suppose, you’re in a vegetable market when the price of vegetables changes like stock price. The prices are sensitive to the quantity of inventory of vegetables in various Indian warehouses (mandis).

Now, you have got this information that there has been a bumper harvest of tomatoes this year, hence its price is about to drop by about 25%. The current price is say about Rs. 20 per kg.

You want to take advantage of this information to make some money. How you can do it?

You will approach a vegetable shop owner who happens to be your very close friend. You will borrow say 100 Kg tomatoes with a promise to return them the next day.

You will sell the borrowed 100 kg tomatoes today, at Rs. 20 per kg, to make Rs. 2,000. Tomorrow, when the price dips to Rs. 15 per kg, you will buy back 100 kg at a total cost of Rs. 1,500.

Now, you can return the 100 Kg tomatoes to your friend and pocket the net profit of Rs. 500 (2000-1500).

This is what is called shorting.

Specialized Investment Funds (SIFs) use this trick with stocks, and it’s what makes them special.

But why do they do it, and how does it work? This is what we’ll try to answer in this blog post.

1. SIFs vs Mutual Funds

SIFs are mutual funds but with a difference, with a special preference.

SIFs are allowed by SEBI to practice shorting.

SEBI does not permit normal pure equity mutual funds to engage in short selling. This strategy is restricted to specific schemes like Specialized Investment Funds (SIFs) or alternative investment funds (AIFs) with explicit regulatory approval.

Normal equity funds are allowed to bet only on price rise (long positions), not on price falls (shorting). But SIFs, can bet on stocks falling, not just rising.

This ability to short up to 25% of their portfolio sets them apart from regular mutual funds. It’s like having a secret weapon in a volatile market.

But what’s the point of this strategy, and why can’t they just stick to traditional investing (long positions)?

In this post, we’ll try to understand the 25% shorting strategy more deeply. We’ll try to answer questions a few deep questions, like:

• Why SIF’s use of shorting makes it so different.
• Why shorting can be a game-changer for investors who want more than just the usual from their mutual funds.

2. What Is 25% Shorting in SIFs?

Shorting means betting on the downward price movement of stocks.

Suppose there is SIF who total AUM

In a SIF, up to 25% of the fund’s money can be used to short stocks. If the fund has Rs. 100 crore, Rs. 25 crore can go into shorting. The rest is invested the usual way, buying stocks, hoping they’ll go up (long position) and will also pay dividends.

Allow me to explain, using an example, how shorting works:

Suppose there is an investor who is anticipating that today the RBI is going to raise the Repo rate by 25 basis points due to inflation concerns. Whenever repo rates are hiked, the stock market falls. Read about how rising interest rates impact the stock market.

With this news flow as his basis, the fund manager of the SIF borrows 1,000 number shares of a company, say XYZ Ltd., and sells them immediately at, let’s say, Rs. 100 per share. This way he gets Rs. 1,00,000 (1,000 x 100) from this sale proceeds.

Within hours, after the RBI’s Chairman’s press conference, a rate hike was announced as anticipated. Immediately, the price of the stock (XYZ) fell to Rs. 80 (Say).

At this lower rate, the SIF buys the 1,000 number shares back. The cost of this purchase was Rs. 80,000 (1,000 x 80)

The SIF then returns the borrowed 1,000 number share, and pocket the Rs. 20,000 difference.

Profit = Sale (Rs. 1,00,000) – Buy (Rs. 80,000) = Rs. 20,000

But has the price of share risen to Rs. 105 (instead of going down), the investor would have to buy the share at this elevelted price paying Rs. 1,05,000 (1,000 x 105). In this trade the person would book a loss of Rs. 5,000

Loss = Sale (Rs. 1,00,000) – Buy (Rs. 1,05,000) = Rs. -5,000

Only SIFs are allowed shorting of shares (with 25% limit) by SEBI, India’s market regulator.

Our traditional mutual funds, cannot use shorting to manage their downward risks. They can only buy stocks to hold them. But SIFs can play both sides – up and down.

This flexibility is what makes SIFs unique.

But why do SIFs need to short the shares?

3. Why Do SIFs Need 25% Shorting Anyways?

Traditional mutual funds only make money when stocks go up, or through dividends.

If the market crashes and the stock prices tanks too, they lose. Stock markets are anyways volatile, but under tough times, the risk of downside momentum becomes extreme. Global events (like war, political turmoil, etc) or loacal news (like GDP growth down-rating, rate changes, etc) can cause more volatility.

These events are not in the control of the market, but it has to bear the brunt of it. This is one of those bigger risks that’s a fund manager is expected to balance.

Hence, SIFs use shorting to protect against these downsides.

For the fund managers, shorting is like an insurance policy. If the market dips, the 25% shorting can work like a cover. How? Because the funds manager can make some money even from the downside movement of the stock.

The gains from falling stocks can offset losses in the rest of the portfolio.

SIFs also use shorting to target specific stocks they think are overpriced. Imagive a stocks which is trading at an exorbitant P/E ratio of say 100. Consistently the company net profits (EPS) trend is not matching the P/E 100 vide. SIFs can identify such stocks and will bet on their price fall (shorting).

Traditional mutual funds can’t do this. They’re can only wait for the market to rise back. They have little or no downside protection.

4. Why Can’t SIFs Stick to Traditional Investing?

Why not just buy good stocks and hold them, like traditional funds?

The answer lies in market unpredictability. The stock market is like a rollercoaster.

Global trade wars, policy changes, or even a bad monsoon can send stocks tumbling. Traditional funds have no way to protech themselves from these price drops.

Shorting gives SIFs an edge.

They can make money even when the market is falling. Without shorting, they’d be as vulnerable as traditional funds in a downturn.

But shorting is a double edged sword. The losses get amplified if the bet goes wrong. Moreover, not many investors would like to imagine their fund managers using betting tricks to make money.

Hence to balance the thing, a 25% limit is used as a control.

This limit is enough to make a difference but not so much that the fund start to look like a gambling den.

There is another way to look at the shorting technique used by SIFs.

Shorting lets SIFs exploit market inefficiencies. Some stocks get overvalued due to hype, like a tech startup with negative profits or one with 100 PEs. Traditional funds can only avoid these stocks. But SIFs can actively bet against them, turning market flaws into opportunities.

5. Examples of Shorting Used by SIFs

Let’s look at some examples to see how shorting sets SIFs apart.

Example 1: The Overhyped Stock

Suppose a SIF invests in a mix of Indian companies.

• One stock, ABC Tech, is trading at Rs. 500, but the fund manager thinks it’s overvalued due to media hype.
• They short Rs. 25 lakh worth of ABC Tech shares (part of their 25% limit).
• If the stock falls to Rs. 400, they make ₹1 lakh profit.

A traditional mutual funds are not allowed to do this. They can just avoid ABC Tech and invest elsewhere.

Example 2: Market Downturn

In 2008, during the Global Financial Crisis, the Sensex crashed by 45%. A traditional fund holding bank stocks would’ve done nothing else but to wait and take the 45% hit.

A SIF, however, could’ve shorted weak banks up to 25% of its portfolio.

If those stocks fell, the shorting gains would’ve softened the blow, unlike a traditional fund’s full loss.

Example 3: Sector Bet

Imagine the auto sector is struggling due to high fuel prices.

A SIF shorts an auto company’s stock, expecting it to fall. If it drops from Rs. 200 to Rs. 150, they profit.

Traditional funds can only shift to other sectors, missing the chance to gain from the auto sector’s decline.

These examples show how SIFs can act where traditional funds can’t. Shorting lets them play offense and defense, giving more versatality to SIFs to manage downside risk and also generate an alpha if possible. Read about what it means by alpha & bets of investment portfolios.

6. The Utility of 25% Shorting in SIFs

What’s the real use of this 25% shorting?

• First, it’s a hedge.
  If the market or specific stocks tank, shorting can limit losses. In Indian market, we have seen FIIs (foreign investors) pulling themselves out suddenly even after weakest of global cues. In such scenarios, shorting can can be a valuable downside risk balancer. It’s like having a backup plan.
• Second, it’s a profit driver.
  Shorting overvalued stocks can boost returns, especially in flat or falling markets. For instance, during the 2008 global crisis, funds with shorting strategies often outperformed others. In volatile market, especially, this ability to profit from declines is a big plus.
• Third, it adds flexibility.
  Fund managers can target specific stocks or sectors they believe will underperform. This active strategy contrasts with traditional funds’ passive “buy and hope” approach. It’s like a batsman (AB de Villiers) who can switch-hit, SIFs too can adapt to any market pitch.

But this is also true that Shorting is risky.

Moreover, Shorting feature also has a cost.

Borrowing shares to short isn’t free, there are fees and interest. These add to the fund’s expenses, which can eat into returns.

Investors need to check if the fund manager’s shorting skills justify the costs.

Conclusion

I see 25% shorting strategy in SIFs like a Swiss Army knife in the backpack of the fund manager.

We cannot see Shorting just as a tool which gives the ability to bet against stocks. If we’ll see it from the overall perspective of investment portfolio mnagement, having the freedom to adapt and minimize the loss, is an excellent advantage.

For the SIF fund manager’s, this means a chance to protect wealth and seize opportunities where others see only losses.

Now, you are ready to ask this question: “Should a small investor like me even try SIFs, or are they too complex? You can read this article on ‘Who should not invest in SIFs?”

Have a happy investing.