I'm curious whether it's possible to short mutual funds in any way? I have given it some thought and I guess that in principle, it is possible using a total return swap. However, I'm sure that the hedging costs of the counterpart as well as other reasons make the setting of this kind of TRS prohibitively expensive (nevertheless I saw plenty of TRS on mutual funds that are long one or more mutual funds). Otherwise, replicating the payoff of the short mutual fund with a portfolio of cheap exchange traded funds would be some sort of cheap but profitable trade (given the high fees of mutual funds). Does anyone know whether it is possible to short mutual funds and if yes, how?
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In principle yes, but there are some operational and legal details. The steps:
- Denote the mutual fund by $F$ (consisting of bonds, stocks, quantum gravity coins, etc)
- The crucial step is that the fund manager agrees to enter into a TRS with you and that there are no legal/ compliance barriers, whereby the fund manager receives part of the fund's return from you (the floating part) and pays cash (the fixed part, but can also be floating if you wish).
- Let's say the notional you want to short is 10% of the fund.
- The fund manager then rotates 10% of the fund into short-term deposits, and the 'new' fund is $F' = 0.9F + 0.1B$ where I use $B$ for the deposits part of the fund $F'$.
- At some time $T$ later, the fund manager receives the return from $0.1F$ from you, where $F$ is the original fund at inception of the TRS. The return from $F$ can be deduced from the $0.9F$ the fund manager is still holding. And you receive the cash return from the $0.1B$ the fund manager had in deposits.
- Only after the fund manager receives $0.1F$ return from you does the fund manager publish the new NAV of the fund $F'$ which will be thus the same as the new NAV from being fully invested in $F$ from TRS inception to maturity $T$.
So whether shorting a publicly listed mutual fund works depends really on the legal and operational stuff.
Hope this kind of makes sense.
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1$\begingroup$ Not sure how a swap over F, rather F', would work in practice (F would likely need to be a third-party calculated reference value to enhance transparency for both sides of the swap). In general a short swap over a fund unit requires a broker dealer to receive performance from client and then hedge itself via (1) other clients who want the long and/or (2) proxy hedges and absorb the basis in the book. If a lot of idiosyncratic risk, appetite and price will likely not be strong. $\endgroup$ Apr 11, 2022 at 18:46
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$\begingroup$ @James Spencer-Lavan In the simplest case, let's say F is IBM stock. So it would be easy to do the swap over F. But I think this is not what you mean, I think you are thinking specifically about publicly listed mutual fund. In this case I don't think it will be possible to set up this structure even if F is third party calculated. However, I think this should be possible with a separately managed fund. For instance a separately managed fund for an insurance company writing a guarantee (put option) on the fund. $\endgroup$– user34971Apr 11, 2022 at 18:59
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$\begingroup$ (continued) As it is separately managed there is likely more flexibility from both a legal and compliance standpoint and operations. $\endgroup$– user34971Apr 11, 2022 at 18:59
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1$\begingroup$ @FridoRolloos OK, I marked your answer. Seems noone else has any ideas how to do it. PS:nice paper on barrier options btw. Just reading before going to bed.. $\endgroup$– T123May 16, 2022 at 20:30
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1$\begingroup$ @T123 Well, you surely took your time to accept the answer ;) On the barrier, as usual there were some annoying typos, not sure which version you have, but probably good to check - I've updated the SSRN note. $\endgroup$– user34971May 16, 2022 at 20:38