Can a Mutual Fund Manager Short Stocks?

Ask your financial adviser about bear-market and long/short mutual funds.

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A stock short is the sale of a stock the investor does not own, with the delivery promised to the buyer at some future time. An investor shorts a stock in the belief that its price will decline, allowing her to buy the stock and deliver it to the buyer for less than the buyer is obligated to pay.

General Obligation

No Securities and Exchange Commission regulation prohibits fund managers from shorting stocks. One could argue that a fund manager has a fiduciary obligation to maintain a portfolio of stocks generally consistent with the fund's stated strategy -- that the manager of a short-term Treasury bond fund, for example, cannot use investors' funds to create a portfolio of short sales of micro stocks. Other than this kind of general civil prohibition against negligent behavior, nothing prevents a mutual fund manager from shorting stocks. In some circumstances, it may be the appropriate strategy.

Bear Funds

Bear funds are mutual funds that short stocks. The manager of the fund generally shorts stocks that in his judgment are overvalued, and holds them until their price declines to what the manager believes to be their true market value. In this sense, a bear fund mirrors a value fund, which generally aims to buy undervalued securities and hold them until they rise to their true market value. Often managers of bear funds invest in derivatives -- financial instruments allowing the buyer and seller to make a bet on the future value of an asset without the obligation to own it. Bear fund managers often use derivatives for hedging purposes -- to limit losses, for example, in the event of a rising market.

Long-Short Funds

Long-short funds hold both long and short positions in the fund portfolio. The fund manager buys stocks that in his judgment will rise in price, and shorts those he thinks will decline. Most long-short funds have complex strategies that involve hedging and selective short positions to increase returns over a benchmark, a practice known as "generating alpha."

Reducing Volatility

The manager of a fund that generally buys stocks for appreciation may short some equities to achieve specific goals, such as reducing volatility. In the summer of 2013, for example, after several years of low interest rates, Ben Bernanke, the Federal Reserve Chairman, announced that the Fed was likely to raise rates in the near future. A manager may hedge against this risk by shorting housing stocks because the housing sector, more than the economy generally, suffers when interest rates rise. If the policy change occurs and the market drops, the housing sector short reduces losses in the fund portfolio overall. If the policy change doesn't occur, the market continues unchanged, and portfolio profits are reduced by the loss in the housing short. Narrowing the range of profit and loss is a reduction in volatility.