Toning down the Big Aussie Short

Characterizing anything as a “big short” these days is a great way to turn heads. Following the success of last year’s Academy Award-winning movie, The Big Short – starring the likes of Christian Bale and Brad Pitt, everyone seems to be looking for the next “big short”.

The movie was as entertaining as it was shocking. Are individuals out there really making large multi-billion dollar bets with other people’s money on the demise of asset prices? Most are not. You see the one thing this movie has done inadvertently, is mischaracterize how the technique of short selling is most commonly used.

Short selling should be viewed more through the lens of insurance; and less through the lens of large-scale speculative betting. Most short selling that occurs today is designed to protect some other portfolio of assets, should prices turn down. Hedging; insurance; downside-protection: these are all more appropriate ways to view the act of short selling.

Imagine you insure your house against fire. You hardly want your house to burn down – yet you sleep better at night knowing that, if it did, you would be somewhat protected from a financial perspective. This is the motivation for most short selling that takes place in the market.

In the world of The Big Short, one would insure their house for many, many times the value of their home. No longer are you now simply protecting against any unforeseen house fire, you are making a high-conviction bet that your house will burn to the ground. Few market participants use short selling in this fashion.

Which brings us to the big Aussie short: property. Many Australian observers have touted Aussie property as the next “big short”. And Australia’s major banks – as holders of the vast majority of Australian mortgages – have been offered up as a proxy that short sellers can use to make their bets.

So is Australian property a good short? Probably not. While Australian property is arguably overvalued in many locations – so what? There are lots of overvalued assets in the world right now. Shorting assets that are overvalued, alone, can be a very risky proposition: as overvalued assets become more overvalued, you lose more and more money on your position.

Now, if an owner of one or more properties could take out some insurance against declining property prices, that may well make sense. Indeed, the banks themselves take out mortgage insurance to protect themselves against defaults for some of their riskier mortgages. And this can effectively be viewed as a “short” exposure to help protect the banks’ mortgage assets. Clearly the banks are not speculating on a property price decline.

For individuals, the implementation of such an insurance policy against property price declines is difficult. While many view a short position in the major Australian banks as a suitable proxy, there are problems with this thesis. The major Australian banks are, by and large, very high quality businesses. Competition is limited, returns earned on shareholders’ equity is high and the banks enjoy an implicit guarantee from the federal government. Furthermore, the major Australian banks pay a relatively high dividend yield – for which any short seller is on the hook.

Short selling can be a very useful tool for investors to manage risk. Most short selling in this world is used sensibly, with a view to protect another portfolio of assets – typically out of sight from market observers – from unexpected price declines. Just like insurance. Characterizing short selling as large, speculative bets on asset price declines – while great for selling movie tickets and newspapers – is less reflective of reality.

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Andrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.

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