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Mutual funds add short selling to their arsenals

Market turmoil is persuading more managers to try the risky strategy that has long been the domain of hedge funds


When making money for his mutual fund investors, Gary Selke wants all the weapons possible to do battle with a stock market downturn.

The chief executive officer of Front Street Capital Inc. says that's why his firm got regulatory approval to be able to short stocks in mutual funds up to 20 per cent of the value of a fund.

"It's another tool in the tool box," Mr. Selke said. "You can manage your risk better ... Quite candidly, there shouldn't be any restrictions [on short selling]."

Front Street is among a growing number of mutual fund managers that can engage in a limited amount of short selling - a tactic common in the hedge fund world.

Dynamic Mutual Funds - a unit of DundeeWealth Inc. - was the pioneer in late 2003 when it got approval to do so for its Power fund family. Sprott Asset Management Inc., Sentry Select Capital Corp., Desjardins Funds, National Bank Securities Inc., Guardian Group of Funds Ltd. and CI Investment Inc. also have the green light to sell stocks short in some or most of their funds.

"It's a trend," said Dan Hallett, an independent fund analyst. "It's part of the evolution of this convergence trend between traditional long-only and ... hedge fund managers."

It's also a way to have a competitive edge, and keep talented managers happy, Mr. Hallett added. "Some of the really good managers would want the flexibility to be able to do some shorting."

For Front Street and Sprott, which also run hedge funds, shorting stocks is part of their culture. Sprott also has "exemptive relief" to short up to 20 per cent of the value of its mutual funds. Other firms like CI and Dynamic requested the right to short up to 10 per cent of the value of their funds.

Going into the August market downturn, Front Street had short positions of less than 5 per cent in its mutual funds plus cash positions ranging from 25 to 40 per cent, Mr. Selke said. "Even with a strong defensive position, our funds were still impacted because our stuff is heavily oriented to natural resources."

Peter Hodson, who manages the $228-million Sprott Growth Fund, said his short position climbed as high as 10 per cent in the late spring, but is now down to 1 per cent of his portfolio.

"Certainly in the short term, I am somewhat bullish," Mr. Hodson said. "But anything [like short selling] that gives you more flexibility and adds investment opportunity is a good thing."

Mr. Hodson successfully shorted Jump TV Inc., which broadcasts international television and sports events over the Internet, when it was trading at about $5.50 on the Toronto Stock Exchange this year. It last closed at $2.50.

He also made money shorting drug maker Patheon Inc. when it traded around $6. The stock last closed at $3.89. "It's a former darling stock," he said. "But it ran into significant troubles over the past 18 months."

Under the Canadian rules on short selling in mutual funds, that stock cannot represent more than 5 per cent of the value of the fund. A manager also cannot use the proceeds to buy more stocks, but must keep it in cash. The cash position must also be equal to 150 per cent of the value of the securities sold short.

"It's a drawback versus a hedge fund because a hedge fund can take that capital from a short sale, and buy a long position," Mr. Hodson said.

Darren McKall, senior legal counsel in the investment funds branch of the Ontario Securities Commission, said the cash requirement is a more conservative approach to short selling, but is in keeping with the image of a conventional mutual fund.

Peter Loach, managing director of fund research at BMO Nesbitt Burns Inc., said he believes short selling is a good tool for mutual fund managers, but noted a lot of them don't use it even if they can.

"A lot of managers are trained long only," Mr. Loach said. "Short selling is a different approach. It takes skill, and does require more fortitude."

Sentry Select Capital has been able to short stocks since last fall, but has not yet taken up the opportunity. "The [Canadian] market trading at 16 time earnings doesn't seem overvalued," said Gordon Higgins, vice-president of equities at Sentry Select. "Should we be in a situation like the tech bubble [in 2000], then I think it becomes very easy to find short positions with limited risk."

While some don't see a need to short stocks now, some big firms like Franklin Templeton Investments Corp. and AGF Management Ltd. are assessing the merits of the strategy.

"The world is changing," AGF's CEO Blake Goldring said. "We will take a look, and see if these are tools that we can use to enhance returns."

Sprott Growth Fund


Since inception 27.69%


The long and short of it

Short selling is a strategy in which investors bet a company's stock price will fall. They borrow the shares and sell them. The hope is that the stock will fall, so that the investor can buy the shares back at a lower price to return them to the lender. The tactic only works if prices fall. Losses can mount if the price keeps rising. Conversely, investors have a "long" position if they buy a stock and hold it, betting its price will rise.

© 2007 The Globe and Mail. All rights reserved.

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