2HRS2GO: Tech shorts pay off for now

COMMENTARY--This aptly sums up the state of tech investing lately: The sector's top performing mutual fund these days is one big short.

The Potomac Internet Short Fund (PDISX) gained more than 50 percent in the first quarter. In any market that's an astounding three-month return, but these days hardly a surprising one. Tech stocks have been in the vanguard the market rout of the past several months, and Internet stocks in particular have been leading the way to the baggage train.

Short-selling remains an esoteric tactic to most folks. "You ask the average investor what is a short fund or what is short-selling all about, and I suspect more than half of them probably won't have much of an understanding of it," says Dale Schmidt, one of Potomac Internet Short's managers.

The transaction is simple to explain, hard to master. You borrow stock and sell it immediately. You cover the loan by buying back shares on the open market. You pocket (or pay out) the difference between the price of your sale and cost of covering. It's the classic way to make money when the market is falling.

Potomac Internet Short is the top year-to-date performer among tech-related funds tracked by Morningstar. Potomac focuses purely on index funds, or in the cases of its short offerings, the equivalent of reverse index funds. The Internet Short fund ties itself to the Dow Jones Internet Index, a group of 40 well-known stocks that Dow Jones believes represents about 80 percent of the Internet universe.

You can easily guess many of the index's components, including Yahoo (Nasdaq: YHOO), Ariba (Nasdaq: ARBA), Amazon.com (Nasdaq: AMZN), eBay (Nasdaq: EBAY), CMGI (Nasdaq: CMGI) and ZDII's owner, CNET Networks (Nasdaq: CNET). Companies in the index must get at least half their revenue from the Internet.

Short-sellers have made barrels of money from those types of stocks over the past year. That doesn't necessarily please Potomac's managers, because the majority of the company's funds are for long-term holders. Potomac Internet Short may be producing marvelous returns, but the Potomac Internet Plus fund has been murdered; the Plus fund is down 50 percent so far this year.

"One of the things that I speculate about...is the fact that if this (Potomac Internet Short) Index is going down as much as it is, there are a lot of people who don't have much confidence in this segment of commerce, or this segment of industry," says Dale Schmidt, one of the short fund's managers. "And it also means that there are an awful lot of people who own or owned these shares who have been hurt as they've gone down, unless they made the decision to go into a short fund. That's unfortunate. I'm not happy."

There aren't many short funds of any kind available, only a dozen, according to Morningstar. Most or all of them were created mainly to offer long investors a hedge; the Potomac Internet Short, for instance, began in December 1999, when the bull market appeared as frothy as ever.

The bull market turned into a Wall Street nightmare that's still continuing, but don't be seduced into putting all your money into short funds. One of Morningstar's senior analysts goes as far as to tell people not to buy bear-market funds at all.

I wouldn't go that far, but he has a point. Playing a short fund is sort of like timing the market, because the minute the bear turns into a bull, short funds get killed. Even Schmidt admits: "I still am certainly a little cautious about it. I don't know how long I personally would stay in a short fund."

It's a dilemma I don't have to worry about, since CNET rightly bars its journalists from shorting stocks. I wouldn't have the chutzpah to do it anyway; it takes a hardened gambler's nerves of steel to short stocks, because if they move in the other direction, you'll find yourself in the deep very rapidly. Just ask Mark S. Jacob, the self-styled genius behind last year's Emulex (Nasdaq: EMLX) hoax; he was motivated by a $97,000 debt stemming from a foolish short.

As Jacob can tell you, shorting stocks is difficult to pull off, even in a middling market. You not only have to identify vulnerable companies or stocks, but you have to find someone willing to loan their shares for a short, and someone willing to buy it. When a large percentage of a company's outstanding stock is already being shorted, getting more shares to short can be difficult. Worst of all, if you put in an order and the brokerage can't find shares to short, you might end up buying the stock outright as the broker automatically fills the order.

Being a long-term shareholder is easy; even if it goes down, your losses are only on paper. On the other hand, a failed short play costs real cash.

But to dismiss shorting out of hand, or even worse, paint all short-sellers as villains (as many individual investors do) is misguided. Shorting is no more immoral than buying-and-holding, momentum trading, or speculating in futures and options. It's just another way of making money on the market.

Make that a very effective way of making money on the market, at least for now. As long as nothing illegal is involved, that's all the justification you need. 22GO>