Long short hedge funds?
July 5th, 2010
Long or short? France are out of the soccer world cup and it’s Warren Buffett’s fault? Berkshire Hathaway short sold Les Bleus to profit from their demise. Negative bets “cause” failure according to those who blame short sellers for the credit crisis. Did the team fail from fundamental problems or shorts? Have sovereign debt spreads widened due to some belatedly realizing there are no risk free bonds or use of credit derivatives? The fact is that markets where short selling and derivatives are not allowed have worse volatility and drawdowns. Anyone not shorting is not hedging. A flight to “quality” so BUY bonds and the yen? Long/short is the way to go.
A portfolio without shorts or derivatives is like a soccer team with no defenders or goalkeeper. Winning funds and teams also require strong management, teamwork and tactical adjustments to nimbly react to changing opportunities. The unhedged, unskilled crowd has underperformed CASH since France won back in 1998; so far my best ever year but commonly regarded as “bad” for hedge funds due to the blow up of one. Hedge funds have demolished long only managers since England won back in 1966; the year long/short was first widely publicized and shown conclusively to be a vastly superior alternative for portfolios. After 44 years how much longer must most investors wait to be allowed to properly diversify and allocate to genuine skill?
Some say short selling is a drag on returns, derivatives must be banned while security analysis and active manager selection are a waste of time. Diversification is “Don’t put all your eggs in one basket” so surely it makes sense to bet that some or most of the eggs will indeed get broken. Shorting and hedging are the way to REDUCE risk. If there is no such thing as investment skill, there is no such thing as sporting skill? Anyone competent knows FUTURE talent is detectable in any field. It just takes hard work, due diligence and experience to find the top performers in advance. Skill must be unconstrained which is why mandating good managers to be long only gets similar results to blindfolding good soccer players. For those who prefer human decisions to computer driven strategies, check out the results of world cup referees not using modern technology.
For long term investors, long/short is safer and better aligned with economic reality than long only. People exposed to rice and wheat price volatility have hedged with shorts and derivatives for centuries but even today there is not enough hedging of equity and credit beta risk. Those seeking consistent performance invest in skilled managers not asset managers. For funds that hold the largest stocks to reduce tracking “error”, BP is yet another reminder that there are no blue chip, buy and hold “securities”. BP stock crashed due to poor management or short sellers? If one hedge fund drops a few billion some urge avoiding all hedge funds but when a stock loses $100 billion they don’t say avoid all stocks. Why?
Avoid all bonds because of Greece? I recently met with a famous fund that blamed the “unprecedented” Greece situation for why they lost money! Proud of their terabytes of “historical” data, amazingly they were unaware Greece had many defaults in the past starting with Solon financial regulatory reform in 600BC and for over 100 of the past 200 years. Investors can learn a lot from the greeks. On trial for daring to challenge conventional wisdom, Socrates’ prophetic last words were “Please don’t forget to pay the debt”. Archimedes invented leverage and was prescient in saying “Give me enough leverage and I will move the world” considering how borrowers have moved world markets recently. It always puzzled me how experts worried about leveraged hedge funds but treated government bonds as risk free. The only risk free rate is zero. Every country is a great place for seeking alpha from long/short NOT long only beta.
Aristotle also offered investment advice. “The aim of the wise is not to secure pleasure but to avoid pain” – the wise short sell and hedge downside risk to avoid portfolio pain. “Hope is the dream of the waking man” – if you hope a losing position will turn into a profit or a long only stock and bond portfolio will fund retirement liabilities you are dreaming. “A great city is not to be confounded with a populous one” – invest with great funds not necessarily the biggest managers. “The greatest virtue is those which are useful to other people” – absolute returns are ALWAYS very useful to clients but they can’t eat relative returns in down markets. Socrates said “I am not an Athenian or a Greek, but a citizen of the world” – invest in alpha opportunities anywhere not the country you happen to be in. “The only good is knowledge and the only evil is ignorance” – financial ignorance is abundant but there have been great returns by the knowledgeable. Small losses are a cost of doing business whereas large losses stem from ignorance.
Too much hope for the future relies on dubious assumptions that “stocks” rise eventually. Long only credit is bad, long only equity is worse, long only commodities is crazy. Over time most equities FALL as any thorough empirical examination of buy and hold confirms. Short selling permits absolute returns from the majority of stocks that go DOWN over time. In my experience bear markets create increased alpha opportunities. As with the world cup there are always more losers than winners which makes it OPTIMAL to have more shorts than longs and benefit from the natural selection and creative destruction of the markets. 130/30 or 30/130 since MOST stocks are sells not buys over the famous long term.
The weakest prey are the easiest. There are far more long positions than shorts out there. Broker dealer analysts issue far more “buys” than “sells”. Long only fund management has much larger AUM while weaker hedge funds tend to be LONG/short rather than long/short or market neutral. Lack of performance incentives means many long decisions aren’t made for legitimate reasons. Too many stocks are bought because they are in an index NOT because they are good investments. Many bonds are held because of investment grade “ratings” regardless of yield. Low returns and high correlation in May 2010 shows little has been learnt from 2008 in terms of proper risk management, reducing market dependence or focusing on truly uncorrelated strategies.
The congenital long bias means shorting attracts a higher percentage of people who know what they are doing. In general the PROPORTION of smart money in shorts is higher than the smart money in longs. Since alpha is generated by the skilled out of the unskilled, position against where the most unskilled money is. Despite what some still(!) say, there is no evidence that risky assets rise over time or compensate for risk. Alpha is zero sum – smart money makes alpha out of dumb money. Identifying dumb money most often means looking for weak longs and taking the other side. There is obviously more dumb money on the long side than the short side.
REAL alternative investments offer alternative returns. I have always evaluated hedge funds with the intent of REPLACING market risk with manager risk. A “hedge fund” that is dependent on up markets for positive performance is of no use. Making money in bear markets is more valuable than absolute returns in bull markets. In good economic times traditional assets perform, people have more spendable cash, greater access to credit and rising real estate values. Individuals and plan sponsors have more earnings to contribute to DB and DC pensions. Foundations and endowments receive more from benefactors. But in negative periods for asset classes, the need INCREASES for absolute returns. In May 2010 we saw a mini repeat of 2008 where thousands of hedge funds MADE MONEY but the “average” manager did not. Beta pollutes many alleged alpha engines. Alternative beta is as unsuitable for risk averse investors as traditional beta. Absolute alpha is what to look for.
While some still believe that shorts and derivatives fuel down markets, the fact is there is not enough use of them to diversify, hedge and make money. Stock market drawdowns need not negatively impact any investor’s portfolio. With so many aspects of people’s lives affected by the economy, their savings and retirement plans ought to be immune to the volatility of long biased equity and credit. The bull market tide went out recently revealing many naked, overly risky, poorly constructed portfolios. And for every GOOG, EBAY or AMZN there are hundreds of failures. We get reminded of the rare stock that actually did do well over the long term but not the many, many more that disappeared or whose IPO price was the all time high.
Most of the greatest trades ever have been shorts. Whether it was John Paulson shorting subprime CDOs in 2007, George Soros the British Pound in 1992, Jesse Livermore USA stocks in 1929 or Munehisa Honma’s rice short in 1789. There have been many attempts to ban short sales since Isaac Le Maire famous short sale of VOC back in 1609. VOC was established to exploit yet anther “Asia boom” like yet another one at the moment. The only way to truly diversify or hedge a long is with a short. Why does conventional asset allocation range from 0% to 100% when investors could use -100% to +100%? Even better would be to acknowledge the failure of stategic asset allocation targets to deliver what investors actually need and put it in SKILLED uncorrelated long/short ALTERNATIVES.
Every investor needs short positions and to use derivatives. It’s called hedging. Few managers have the capability to make money in bear markets. Sadly too many fail in due diligence to show they have the quality of risk management, strategy testing and expertise to deliver positive performance in negative periods. Despite the lessons of thousands of years little has been learnt about decorrelating a portfolio to underlying risk factors and immunizing against economic volatility. The fact remains that long short is better for conservative investors than long only. Eliminate beta risk factors and focus on alpha from long short market timing and skilled security selection. The TRUE drivers of portfolio performance.
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