I made a major change in my short stock selection process at the beginning of 2013. At that time my selection process was based solely on identifying fundamentally overvalued equities but beginning January 2013 I also added a strong emphasis on those stocks with high volatility, asymmetric beta and negative momentum.
After several attempts trying to put together a long stock portfolio I have decided to simply use the SPDR S&P 500 Trust ETF for my long position. I have realized that if I cannot beat the market on the long side — I might as well join it.
This means any alpha that might possibly be generated is coming from the short side. My goal is to try to have the short portfolio break-even in an up-market or at least lose as little as possible and hopefully have the short portfolio generate a large enough gain in a down-market to cover the loses of the S&P 500 long position. This requires selecting short stocks with a high degree of asymmetric beta.
For further information on investing and stock selection please see the Recommended Books web page.
VARYING THE NET EXPOSURE
On August 31, 2018 I came to the conclusion that perhaps my short stock selection process using negative momentum might provide a guide for varying the net exposure. One thing that had become apparent to me was when the short portfolio was trending up causing the short portfolio to lose money I found there are less short stock opportunities than when the short portfolio was trending down and I was getting a positive return from the short portfolio.
By holding each short stock to 1% of the fund equity I could vary the amount invested in the short portfolio depending on the number of short stock candidates available and thereby vary the net exposure. Given my past results the number of short stock candidates should increase if the short portfolio falls leading to a larger percentage of the fund equity being invested in the short portfolio and thereby increasing the short portfolio gains.
Conversely, the percentage of the fund equity invested in the short portfolio should decrease when the short portfolio rises and I have fewer short stock candidates thus helping to limit the loss from the short portfolio.
For example the short portfolio begun on August 31, 2018 with 13 short stocks would mean the short portfio was 13% of the fund equity and the net exposure would be 87%. On September 28, 2018 the number of short stocks rose to 18 so the net exposure fell to 82%, on November 2, 2018 the number of short stocks rose to 34 so the net exposure fell to 66% and on November 30, 2018 the number of short stocks rose to 38 so the net exposure fell to 62%.
One of the benefits of limiting the amount invested in each short stock to 1% of fund equity was being able to increase the overall capacity of the fund. This is because the capacity of the fund is limited solely by the capacity of the short portfolio. The long portfolio capacity is for all intents and purposes unlimited given the SPDR S&P 500 Trust ETF has net assets in excess of $250 billion and an average daily trading volume exceeding $15 billion.
If the dollar amount invested in the short portfolio is fixed then with fewer and fewer stocks in the short portfolio the dollar amount invested in each individual stock rises. At some point a practical limit is reached for finding enough outstanding stock of that company to short thus effecting the capacity of the short portfolio. This would lead to decreasing the size of the fund to accommodate the potential fixed capacity of the short portfolio. By holding each short stock to 1% of the fund equity thus varying the capacity of the short portfolio based on the number of stocks in the short portfolio I will be able to maximize the capacity of the fund.
UPDATING LONG STOCK AND SHORT STOCK PORTFOLIOS
I plan to update my portfolios at the end of each month instead of once a week. If the last day of the month falls on Saturday through Tuesday I will update the portfolio on the last business day of the preceding week. If the last day of the month falls on Wednesday through Friday I will update the portfolios on the last business day of that week. I try to publish the updated portfolios at least a couple of hours before the market closes to counter a common problem with trying to create a realistic measure of fund performance. To avoid the accusation of look-ahead bias I make every attempt to publish prior to the market closing on Friday (or the last business day of the week). Very rarely (usually due to vacation but once due to a software glitch) I find I have to publish after the market close. Basically, the virtual Hedge Synergy Fund exists in real time (no back testing) and tries to mimic real trading using existing data at the time of executing its "trades".
I will continue to hold a position unless the facts that I have based my opinion on change or the company experiences a merger, is taken private, delisted, bankrupt or the stock price falls below $3. When stock undergoes a merger, is taken private, delisted or bankrupt during the month, the stock will remain in the portfolio until I update the portfolio at the end of the month — but since the market price is frozen the stock's position essentially becomes a cash position.
When updating the stocks in the long and short portfolios I use the closing balance of the prior portfolios as the beginning balance of the new updated portfolios and then equally weight the stocks within the portfolios.
I usually adjust the ratio of the long portfolio to short portfolio at the end of the quarter, although I will adjust the ratio during the quarter if I believe it is warranted.
To simplify the web site updating I group the portfolios by quarterly series. I use a numbering system based on a quarterly time period with the updated portfolios within the quarter then designated by letter. For example, the first portfolio of the fourth quarter of 2008 is Portfolio 18-A, the second portfolio is Portfolio 18-B etc., with the first portfolio of the first quarter of 2009 being Portfolio 19-A and so on.
Because of the advent of stronger regulations by the SEC and an increased demand for information and transparency from institutional investors, it is essential to have the proper procedures in place to handle the increased paper work and regulatory requirements. That is why I believe very strongly in using an outside administrator who has the experience and expertise to handle this fast changing environment. A hedge fund manager should spend his time analyzing stocks, not expending time and energy on office management. Those tasks should be delegated to others by the fund manager (see Administration).