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Q&A: The tall and short of short funds

You're not likely to find a better reflection on Wall Street of the Internet sector's collapse than the Potomac Internet Short Fund.

In a bear market short funds tend to among the highest performers, though very few funds focus exclusively on short selling. Shorting a stock means borrowing shares to sell then, then "covering" the loan by buying the company's stock on the open market. Short sellers profit from the difference between the price at which they sold and the price of the replacement.

So far this year, Potomac Internet Short has gained more than 50 percent, making it far and away the top performing tech-related mutual fund. It is one of the two tech funds, out of 176, that has posted gains in the first quarter. A member of a family of index funds, Potomac Internet Short is tied to the Dow Jones Internet Index of 40 stocks.

ZD Inter@ctive Investor recently spoke with Dale Schmidt, one of Potomac Internet Short's managers.

When did you start Potomac Internet Fund?
The fund started on Dec. 1, 1999.

The market was still pretty heady then. What was the reason for starting it at that time?
I wasn't here at the time, but what I have been told is that basically the investors wanted it.

They liked being able to address the Internet. We have an Internet Plus fund, and the short fund gave them the opportunity to hedge their investments in the long fund, and also if they wanted to take some money out of the long fund, but not put it into money market funding.

How have money in-flows progressed since the fund began?
They've improved. There have been ups and downs. As the Internet index has gone up and down, they go up and down.

Short funds are kind of specialized beasts still. 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, but we do have some individual investors and we have a fair number of investment advisors who use these funds quite regularly.

How do you market something like this? Do you do a lot of marketing for it, or do people just gravitate toward it as the stock market has tanked?
We have done some targeted marketing; we haven't done too much broad marketing. We're in touch with some of the advisor groups; we work with financial professionals.

Although I've noticed--just sitting here from time to time, I get a fair number of calls, or we're starting to get a fair number of calls-the word is seeping out. Part of it, I guess, is just people seeing lists where our name appears, and they call us to find out more about the fund.

They see the year-to-date performance, things like that?
Yeah, some of that lately has been pretty extraordinary, so they figure they have to get on that train.

Being that it's a short fund, would you ever close it at some point? Would it ever become limited by size at all?
We haven't really had to face that at this point. I think right now the main concern is how far is the market going to sink? When it sinks, a short fund is going to do well, but looking at the number of companies that are really having serious problems, you have to ask the question of, "Who's going to buy the shares that we're shorting?"

What kind of lifespan do you see for this? With everything already trading so low, how much money is left to be made shorting Internet stocks?
I don't know. We haven't seen a bottom to the Index yet, and as a result, we haven't seen a top to the fund. And we don't have so many people beating down the doors that we have to worry that we can't find shares to short.

You just answered my next question, which is if you're having trouble finding shares to short.
Not right now. But part of it too, look at the Internet index--the Dow Jones folks have changed that from time to time as companies either merged or gone bankrupt or whatever or just aren't really representative anymore of the industry. They've taken companies out and put companies in, so that has created new opportunities.

The composition or the weighting of your shorts, does that track the Dow Jones Internet's weighting exactly?
Not exactly. It's close, but not exactly. We do a little bit of adjusting; it's just in the way we invest. We aren't looking to choose home run hitters or to weed out complete losers.

One time I remember when we made a buy, based on the amount of money we had to spend and what we wanted to accomplish, we cut off a few of the very low percentage weights and concentrated on stocks that were weighted over a certain percentage. It was a fairly low number.

But most of the time we just buy the whole basket.

How do you know when to cover a short, or do you just use a fixed time period?
We basically cover shorts when money goes out of the fund. We short when money comes in, and we cover when money goes out. We're watching this thing every day and keeping track of the fund flows.

Which stocks have proven to be your most profitable shorts since you started?
We don't really keep that data. We buy the basket, we sell the basket. We short the basket, we cover the basket. We just really don't keep that.

Just from observing, would have any sort of rough idea?
No. I know what's more heavily weighted, but that doesn't reflect profitability.

There's at least one Morningstar analyst who tells people to stay away from bear-market funds. This is what he wrote:

    "Despite their stunning gains of late, don't buy a bear-market fund. There are two ways to do it, and it's unlikely either approach will work well for you.

    "First, you can buy a bear-market fund when you think the market is about to fall, and sell it when you think the market is going to rebound. But that won't work. The pros can't do it, and a Morningstar study shows that individual investors haven't fared any better.

    "Buying and holding a bear-market fund is an even worse idea."

Well, let me start with the second piece first. I always thought that was true too, and I still am certainly a little cautious about it. I don't know how long I personally would stay in a short fund.

We've just taken a look at our quarterly results and our one-year results. If you had bought Internet Short a year ago, basically a year ago today, the share value, the NAV (Net Asset Value) was $43.18. Last night it closed at $104.92, and that's a 165 percent return.

Of course, it's attributable to the extraordinary downfall and the sliding of the Internet index. But let's say you bought on April 5 instead of March 31 of last year, you still would have done pretty darn well.

It turns out that the fourth quarter of 2000 was the best (quarter). And the reason was, the NAV on the fund had fallen over time, had kind of drifted off, until at the end of September it was $39.74. By the end of the year, it had returned 83 percent.

So, the answer is, I guess if you held this fund for three or six months or even a year, you have done pretty well.

Finding those opportunities is kind of difficult, and that gets back to the beginning part, the first statement you read or the first question. The market timers really do have a tough task ahead of them, although the way the Dow Internet Index has been, it's been fairly easy to make some money on short funds.

But as a rule, I think there's more up and down in the market than there's been, and I think it is difficult to time the market.

The long-term goal of the Dow Jones Internet Index, according to its own description, is to represent 80 percent of the universe of Internet stocks. Would you say that your fund's performance means 80 percent of Internet stocks are just bad?
No, I wouldn't say that. What I think can be said is that the Internet business plan, the Internet market model, hasn't worked out as well, as fast as a lot of investors thought it would. And when they saw it wasn't working out, they moved away from it. And when and if it improves itself, they'll come back and they'll be buying the shares again. And the Short Fund will go down.

If you look at what Greenspan has said, if you look at what has been said in the general business press, there are a lot of companies that are using the Internet effectively to improve the way they do business. But some of these companies that have tried to specialize in it, if you will, haven't been as successful.

At what point do you think it will be difficult to find a stock to short, if ever?
Well, I assume if the Dow Jones people keep adjusting the Index-you know, every time they change the index, that gives us opportunities, and that provides a new batch of stock to deal in, whether you're buying or selling.

And the other thing is, as long as there are people out there willing to buy it, it's possible to short it. There's somebody on the other side of that transaction. Now either it's buyers, or it's market makers who eventually are going to go bankrupt because they've got so much of this stock and they're unable to unload it.

Do you think market makers at this point really own a lot of these Internet shares?
I don't know. I know how the system works, but I have no idea what they're holding.

A lot of folks see short sellers as evil, villainous people. How much negative feedback have you gotten related to the short fund?
None. One of the things that I speculate about as I ride to and from work, for example, is the fact that if this 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. 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.

And to the extent that companies need to raise money, and improve their business, or they get new ideas and they need to finance them, they need to have a vital market. And this one's not looking real vital right now.

Would you say the Potomac Internet Short Fund is a good reverse indicator of sentiment about the sector?
I wouldn't say that, no. We look at it pretty much as a tool for investors to use in certain tactical situations where they can make money while the index is going down.

Most of us, as long investors, if something is going down, we get out of it, hope to save our skins, and we wait until a better day. But people who use short funds, when they get out of long funds, they go to short funds. They don't have to go to money (market) funds, they can go to short funds.

How much should average investors rely on short funds as part of their overall investment mix?
I'll rely on the financial advisors and the financial planners for that kind of a decision.

We've done some talking just informally around the office trying to figure it out whether, when the market looks like it's cresting and starting to go down, do you take all of your money and put in short funds, or do you move out and put in 25 percent, and we have no idea. We've talked about it endlessly and none of us has an idea.

I'm sure there are advisors out there and financial planners who have models. And they feel that they're carefully and rationally moving their clients' money from one fund to the other. They don't tell us in what percentages or what proportions or when; they just do it.

How much of the inquiries you're getting nowadays is coming from people who don't know anything about short selling, and how much is coming from more educated, more aware investors?
My information base is perhaps a dozen or a couple of dozen calls in the last week from individual investors. What I'm hearing is mostly people who are reading statistics that say the Internet Short Fund is up X percent over Y period of time.

What is not possible for me to gauge, but what I'm a little concerned about, is whether they really do understand the underlying principle of short-fund investing or shorting generally, or whether they're just looking at performance numbers and trying to find something that's going to make them some money while the market's in the tank. And I'm a little concerned that they may very well not fully understand it, and if they don't, then they may not have a good sense on what their timing ought to be in getting in or out of this fund.

If, in fact, the market is going to find a bottom here sometime in the next few months and then start going up, then what they're going to be doing is buying high. And that would be an unfortunate decision.

If, on the other hand, the Index is going to keep going down for a while longer, they'll get some value out of it. They won't get as much value as the person who got in last month or last December, but they'll get some value out of it.

I'm not in a position to (advise them about) that...They need to sit down with an advisor and have a risk analysis taken.>