Long short?
June 28th, 2010
France are out of the 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 that blame short sellers for similar financial implosions. Did the team fail due to fundamental problems or short sales? Did the Euro fall in recent months because of structural defects or shorts? Have sovereign debt spreads widened due to amateurs belatedly realizing there are no risk free bonds or professionals using credit derivatives? Some say short selling is a drag on returns, derivatives and shorting should be outlawed while security analysis and active manager selection are a waste of time. If there is no such thing as investment skill, is there also no such thing as sporting skill? Anyone competent knows FUTURE talent is detectable in any field. As any good coach will confirm it just takes hard work, due diligence and experience to find the top performers in advance. Skill also must not be constrained which is why mandating good managers to be long only gets similar results to blindfolding soccer players. And for those who prefer human decisions to quant strategies I suggest they take a close look at world cup referees “accuracy”.
A portfolio without shorts and derivatives is like a soccer team without defenders and goalkeepers. A winning fund requires 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. Good hedge funds have demolished most long only managers since England won in 1966; the year long/short was first widely publicized and shown conclusively to be superior. For long term investors, long/short is much safer and better aligned with actual economic reality than long only. Those seeking consistent performance invest in skilled managers not asset managers. For funds that hold the largest stocks to minimize 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? Like every country Greece is a great place for alpha. I recently met with a manager that blamed the “unprecedented” Greece situation for why they lost money! Proud of their petabytes of “historical” data to analyze, amazingly they were unaware Greece had many defaults in the past starting with Solon trying to sort out the debt situation 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 large borrowers have moved world markets recently. It always puzzled me how experts worried about leveraged hedge funds but regarded government bonds as risk free.
Aristotle also had some investment advice. “The aim of the wise is not to secure pleasure but to avoid pain” – the wise short sell, buy puts 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 traditional portfolio will fund retirement you are dreaming. “A great city is not to be confounded with a populous one” – invest with great funds not necessarily the biggest asset gatherers. “The greatest virtue is those which are useful to other people” – absolute returns are 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 global alpha opportunities anywhere not the country you happen to be in. “The only good is knowledge and the only evil is ignorance”. Sadly for investors ignorance in finance is plentiful but there has been good performance by the knowledgeable. Don’t let the evil of down markets damage portfolios. Small losses are the cost of doing business; large losses are evidence of ignorance.
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 and volatility 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 unreliability of long biased equity and credit. The bull market tide went out recently revealing many naked, overly risky, poorly constructed portfolios. Too much hope for the future relies on dubious assumptions that “stocks” rise over time and “bonds” will repay you. Long only bonds is bad, long only stocks is worse, long only commodities is crazy. Over time most equities FALL as any thorough
empirical examination confirms. Short selling permits absolute returns from the majority of stocks that will go DOWN over time. In my experience bear markets create MORE alpha opportunities. Just like in the soccer world cup there are aways more losers than winners which means it is better to have more shorts than longs to keep aligned with the natural selection property and creative destruction phenomena of the markets.
The weakest prey are the easiest. There are more longs than shorts out there. Lack of performance incentives means many long decisions aren’t made for legitimate reasons. Some 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. 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. 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 usually means looking for weak longs and taking the other side. There is usually more dumb money on the long side than the short side.
Alternative investments exist to offer alternative returns. I have always evaluated hedge funds for REPLACING market risk with manager risk. A “hedge fund” that is dependent on an up market for positive performance is of no use to investors. Beating a benchmark is irrelevant. 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 cash 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.
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, the Munehisa Honma’s rice short in 1789 or Isaac Le Maire famous short of VOC in 1609. 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 static asset allocation and put it in SKILLED long/short strategies. Every investor needs short positions including during BULL markets. It is called hedging. Few managers have the capability and skills 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 market periods. Despite the lessons of the thousands of years little has been learnt about decorrelating a portfolio to underlying risk factors and immunizing against market volatility. But the fact remains that long short is better for conservative investors than long only.
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