“Don't gamble! Take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it." — Will Rogers
My short stock selection is based on identifying overpriced equities using behavioral heuristics with an emphasis on concentrated portfolios with a high active share and asymmetric beta.
If a selected short stock does not go in the right direction, while it may be too late to follow Will Rogers' advice of "don't buy it" (or don't sell it short), I can at least close out the position and select another short stock. Basically, I want to let my winners run and cut my losses short.
After several attempts of 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. As far as my long portfolio is concerned I have come to the conclusion 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 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 — not a very easy task.
For further information on investing and stock selection please see the Recommended Books web page.
While stock selection is important, what really matters is the management of risk. When I refer to risk I am not talking about volatility — I am referring to the risk of loss. Risk and return are two sides of the same coin, and, since risk and return are directly correlated, reducing risk of loss means reducing return. Because the risk/return trade-off is a moving target, a long/short equity hedge fund manager should try to find the long/short portfolio ratio that will result in breaking even in down-markets — which more than likely means underperforming in up-markets.
Since the first rule of investing is to not lose money (and the second rule is to remember the first rule), the ideal rate of return in down-markets is 0%. Any rate of return higher than this means that you are taking on excessive risk. If you are earning a positive return in down-markets (up-capture of inverse S&P 500 returns), then when the market turns up you will either end up losing money or you will have reduced the potential up-capture of the market's positive rate of return.
A perfect example of excessive risk is the performance of the virtual Hedge Synergy Fund from 09/28/07 to 05/29/09. As you can see, the virtual Hedge Synergy Fund achieved very high up-capture of the inverse of S&P 500 returns, but it managed to achieve even higher down-capture of the S&P inverse returns.
Another example occurred on February 12, 2016 when the S&P 500 was down approximately 9% for the quarter and the NAV was up approximately 8%. I was making an excessive positive return in a down market so I increased the net exposure from 40% to 60% by decreasing the size of the short portfolio. Please note, given that this was by pure happenstance to be the beginning of a short squeeze this may look like it was a deliberate act based on hindsight so I would suggest looking up the Twitter posting on Sunday, February 14, 2016.
The idea is to break even in down-markets — to not only avoid losing money but to also avoid making a positive rate of return. You want to reduce any positive return thus reducing risk so as to position the fund to maximize the up-capture ratio when the market turns up. If long/short equity hedge fund managers find they are consistently making a positive return in down-markets, they should adjust the ratio of their long to short portfolios until they bring the down-capture ratio (up-capture of inverse returns) to 0%.
Long/short equity hedge fund managers should try to find the long/short portfolio ratio that will result in breaking even in down-markets and then should simply accept whatever up-capture they are given by up-markets. If you can achieve an up-capture greater than 30% on average in up-markets while trying to break even on average in down-markets, you can beat the market in the long run. The last thing you want to do is to try to beat the market on the way up. To do so only sets you up for losses on the way down (see Ed Easterling's "Rowing vs. the Rollercoaster").
For a discussion of capture ratios and graphs of long term rates of return that can be achieved with various combinations of up and down capture ratios see Capture Ratio Strategy.
I think I should say a few words about market timing. In short, don't try to attempt it. The idea that someone has the precognitive ability to know what the market is going to do tomorrow, next week, next month or next year is, to say the least, absurd. I know there is going to be someone (probably a lot of someones) who believe that they have the skill to know when to try to achieve a high up-capture ratio in an up-market and that they will have the instant genius to shift gears when they have "determined" that a down-market is imminent. I believe these people are simply deluding themselves. The minute you think you should zig the market is probably going to zag. The best strategy is to position yourself to take advantage of any contingency. That is, maintain a long/short portfolio ratio that will break even in a down market and which will give you a positive return in an up-market.
The important thing to remember is that, whatever the long/short portfolio ratio, it should not be calculated by trying to time the market. While there is nothing wrong with making a guess on the direction of the market — you should just always make sure you avoid acting on it.
VARYING THE NET EXPOSURE
I have been holding the net exposure at 30% for the last few years. I have come the conclusion that perhaps my stock selection process might provide a guide for varying the net exposure. One thing that has become apparent, when the short portfolio is trending down (therefore making positive gains) I find there are more short stock opportunities than when the short portfolio is trending up (and I am losing money). Basically I am not proposing varying the net exposure by trying to time the market but based on the number of candidates from my short stock selection process.
I have decided it might be a good idea to limit the total investment in any one short stock to a maximum of 1% of the fund total with a total maximum short portfolio percentage of 40% of the fund total. This would mean that the current short portfolio (begun on August 31, 2018) with 13 short stocks would be 13% of the fund and the net exposure would be 87%. If the number of short stocks rise to 32 then it would mean the short portfolio was 32% of the fund and if the number of short stocks in the portfolio rises to 40 then the short portfolio would be 40% of the fund. It the number of stocks rose beyond 40 though the short portfolio would remain at 40% of the fund.
This could possibly be beneficial in two ways. The first is the possibility of increasing net exposure in an upward trending market while decreasing net exposure in a falling market (again, in a purely mechanical fashion, not on trying to guess the direction of the market). The second is fund capacity. With fewer and fewer stocks in the short portfolio the dollar amount invested in each individual stock rises if the total dollar amount of the short portfolio remains the same. At some point a practical limit is reached for finding enough outstanding stock of that company to short. By limiting the percentage of the funds invested in each short stock to 1% of the fund, I can try to make sure the capacity for shorting that individual companies stock is not exceeded.
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).