Is there was a way to build a portfolio of non-leveraged short positions? This is new territory because industry’s focus on building models for a long-only focused market, but also because short, and long-short enter the alternative or hedge territory, an underrepresented segment globally. The idea of a short index does not exist while the short ETFs are in their nascency. As global money managers still are predominantly ‘buy and close’ rather than buy with a short hedge. As markets become harder to understand, the lines between trading and investing have finally started to blur.

Shorts balance the long pressures. Long and short isn’t a conflict, but as essential an aspect of investing, like in trading. Moreover, why should investing be long (buy) only, while trading is both long and short (sell) and long-short? Human beings are predisposed to long only because it’s an emotional thing, long only is growth, we bet more on growth than on decay. Betting on decay seems fearful, not positive. Hence, it’s harder to justify, comprehend a short only view or perspective, build a Short Index. However, the reality is a lot different. We would like to believe that there is more growth and less decay, hence long-only strategies are more relevant. This is why the behavioral endowment theory. We own things, we get biased, and hence poorer decision-making. A trader’s life is different he trades both ways and is always close to the short idea. Even arbitrageurs understand short better as they may look at ETF pair models, Short Coffee, Long Zinc.

So how do the Short ETFs work? For any up move on the asset value, there is an equivalent drop in the short index value and vice versa. The underlying index is up 10%, the short ETF on the underlying is down 10% or vice versa. It was a novel idea to introduce a non-leveraged paper for shorting. This was a product innovation. While there is an advantage that the loss with such instruments is limited to the loss of purchase price, the fact that ETFs have to maintain a fixed leverage ratio leads to compounding the error. Putting simply, a short ETF may not mirror a Short position. This creates problems for anyone using Short ETF’s for a complete hedge. So though there is a convenience the respective hedge instrument has a poor design. A Short Index would solve this problem, as ETFs based on short indices will mirror the short benchmark perfectly. Currently, the Short Indices industry is non-existent.

So how do we create a short index innovation? One way is to invert the existing long index (dow30), which as we see is psychologically not attractive in a secular uptrend, as investors don’t want to bet on decay and into illiquidity. The inverted short Index would work more like a volatility index, flaring up occasionally and stagnating the rest of the time, or falling rest of the time, if the underlying is rising.

An ideal short index should be an index that understands decay and can offer a timing tool to the investing community, going cash when the markets are in a secular total up move, while selecting underperformers out of the universe and capturing alpha as underperformers fall, stagnate and decay. A successful and popular short index has to work both ways, both in an active and passive style. The absolute active return index should have an ability to control drawdowns, conserve capital and deliver.

But how do you discover alpha in a bull market while ‘Shorting’? It’s like asking are there short opportunities that exist in an up trending market? Yes. And they are spread temporally (across time frames). There are stocks in the S&P500 that are underperforming (falling) by more than e.g. 10% quarterly while the markets are outperforming (rising). Is it possible to find such opportunities for different holding periods? It’s not a hard question for a trader, but what we are talking about here is a portfolio approach to shorting opportunities which can be called a short index.

There are always opportunities to short even in a secular uptrend. And a short portfolio that can see in the past can deliver supernormal returns from any starting point. This can illustrate that our understanding of alpha is limited. It also means that shorting a market can be profitable at all times if you have a superior selection temporal system. These results also challenge the idea of a conventional hedge which is believed to be a cost. A short Index running parallel to a Long Index and both generating a profit proves that market neutral portfolios are a costly redundancy. Moreover, why would you want to pay for a short-term hedge when you can be profiting from it? But then search for this manager is a cost. And by the time the resourceful investor finds him, he may be ready to underperform. Timing is for active managers and statistics are stacked against them.

What to do? There should be a way to build a passive short index, which is better than an inverse index. This means that if there was a way to better the inverse index i.e. mirror the inverse of a popular benchmark, but a smarter inverse. It falls when the market rises and it rises when the market falls, but there is a difference. The new inverse falls when the markets rise but not proportionally. For example, if the market rises 10% and the new inverse falls 9.5% we have a better inverse. Similarly, if the market falls 10%, the new inverse rises 10.5%. This gives a better cost of a hedge to the investor. If he wants to hedge he has a tool, which is smarter than the regular inverse. It simply reduced the hedge cost for the investor.

Okay, that’s brilliant. But why has it not been done? There are many reasons. First; the market is predominantly ‘go long or go cash’ thinking. Second; Market understanding of hedge means a fixed cost. Third; There is simply no investment framework that can be applied both on the long and short side of the market.

Where’s the smart beta camp? Should they be building this? Is it not their job to offer hedge solutions to the investors? If they are so good in offering smart beta solutions, where are the smart hedge solutions? Should the smart beta not give us smart outperforming solutions both on the way up and the way down? Why have failed to do so? The answer is the same. The smart beta providers don’t have a framework that can work both sides. The rules smart beta talks about is about beating the market at the same risk. The rules don’t apply on the short side. If the market falls, you have the inverse index, you can use it 2X, 3X. Building more efficient hedge solutions is new age thinking. But unfortunately, there is a limited time. Whenever we have another 2008, the money that has shifted to ETF’s, which might be feeling lucky paying a low fee, will feel the heat, not only because of lack of efficient hedge ETFs but because of sales impetus behind our preordained long thinking.

The smart beta challenge. If the smart beta is really smart and it claims to beat the market on the way up at the same risk, then it should be smart also on the other side of the equation, on the journey down. If your smart beta provider can do it, that is the one to be managing your money. If it can’t-do it. You need to move to the smart beta provider who can.

The smarter beta challenge. The short innovation has to begin now. Building Short Indices for different rebalancing periods starting 30, 60, 90,180 days etc. So what do these Indices do? They become proxies for hedging for different periods for different universes. So any investor who wants to hedge looks at his cost at any given point of time for a certain universe. The short active and passive indices also address the potential wall of worry heading ahead of us in 2016-2017. Hedging as a science needs to evolve and we never needed it as much as we need it now.