How to Profit in a Stock Market Downturn

By Tori 4 years ago

With the coronavirus spreading around the world, the vast majority of mutual funds found few refuges, with some falling 20 percent or more.

But a select few funds managed to find profits. Here are three, which shorted American stocks and placed bets on small Chinese companies and long-term Treasury bonds.

China, where the virus appears to have originated, might seem an unlikely spot for investments these days. And small-capitalization companies there, which are usually more exposed to financial hardships than large-capitalization ones, might seem especially risky.

But to think that is to misunderstand Chinese small-caps, said Tiffany Hsiao, lead portfolio manager of the Matthews China Small Companies Fund.

Chinese small-caps are arguably financially sturdier than their large-cap counterparts, which typically rely on government loans, she said.

“They were capital-starved when they were growing up, so they had to generate their own cash flows. They don’t go out and spend two years building a building before getting their first cent. The customer better pay first,” she said.

The best of them, she said, thrive in industries like consumer products and health care that have grown with China’s middle class.

She said several of her picks stand to benefit from the pandemic.

Joyoung, a maker of small household appliances, has had a surge in sales during China’s lockdown, she said. The appliances were already popular with China’s largest consumer cohort — millennials.

“They’re now moving to an age when they’re having kids, and they’re struggling to learn to make food at home,” she said.

Another of her holdings is CanSino Biologics, which has developed an Ebola virus vaccine and is now working on one for Covid-19.

Ms. Hsiao’s fund, which has a net expense ratio of 1.5 percent, returned 10.58 percent in the first quarter, compared with a loss of 19.6 percent for the S&P 500.

As its name hints, the Grizzly Short Fund comes into its own during bear markets. It sells short stocks its managers judge to be overvalued, and that strategy tends to work better in falling markets.

In short selling, an investor bets that a stock will sink. The investor borrows the stock and agrees to sell it to someone else. If, as hoped, the stock does drop, it’s bought at the lower price and delivered to that buyer. That difference, minus transaction costs, is the short seller’s profit. If the stock rises, the short seller loses, as the promised shares still must be bought and delivered.

Greg M. Swenson, a portfolio manager of the Grizzly Short Fund, said he and Kristen J. Perleberg, who runs the fund with him, rank stocks based on a variety of factors, including lack of financial discipline and potential for earnings disappointments. They short those that rank worst.

“We’re looking at the weakest end of the spectrum — the most expensive, the lowest quality and the lowest growth,” he said.

Mr. Swenson said they also use strict rules to decide which bets to abandon. They pull out if a stock rises too much — typically, if it outperforms the market by 20 percent or more — or grows to more than 2 percent of the portfolio.

“We like using a quantitative approach, because it takes your emotions out of it,” he said.

With a typical stock fund, holdings shrink as they lose value. But in a short fund, everything is upside down, Mr. Swenson said. “If a stock is going against us, it’s getting bigger every day, and our losses are compounding.”

The Grizzly managers short individual stocks. They don’t, like some competing funds, short indexes representing entire sectors. Even so, their short positions have lately clustered among consumer discretionary, information technology and industrial shares. Together, those represented about half the portfolio.

Mr. Swenson cautioned that the fund isn’t for everyone. It’s intended to provide diversification within a broader portfolio, especially for investors with lots of exposure to stocks. It can help hedge the stocks’ downside risk.

Anyone pondering investing should understand that “if the market goes up 20 percent, this fund is going down,” he said.

The Grizzly fund, with an expense ratio of 1.6 percent, returned 25.8 percent in the first quarter.

Like short sales, long-term U.S. Treasury securities tend to thrive during stock market routs, when many investors trust the Treasury to protect their money.

The managers of the T. Rowe Price U.S. Treasury Long-Term Fund run their offering accordingly, emphasizing safety first.

“This fund was established in 1989,” said Brian J. Brennan, the portfolio manager. “At the genesis, the mission was ‘Keep it safe.’ The guidelines have changed very little.”

That means Mr. Brennan and Michael K. Sewell, the associate portfolio manager, buy only AAA-rated government bonds with maturities of 10 years or more.

Eighty-five percent of those are U.S. Treasuries or U.S. Treasury Inflation-Protected Securities. The latter hedge against the possibility of future inflation, which eats away the returns on bonds.

The rest of the portfolio is so-called Ginnie Maes, mortgage bonds issued by the Government National Mortgage Association but backed by the U.S. Treasury.

The fund is “a defensive product,” Mr. Sewell said. “But we want t
o make sure, when things are looking better, portions of the portfolio provide positive total returns.”

In the first quarter, with a severe recession looming, interest rates dropped, stocks mostly sank and long-term government bonds soared.

“Long Treasuries have historically been a great hedge for equity drawdowns, like the one we’ve recently seen,” Mr. Sewell said.

That was spectacularly true in the quarter, when the T. Rowe Price fund, with a net expense ratio of 0.3 percent, returned 21.43 percent.

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