Scroll to very bottom of page to download a printer friendly PDF version

Distinguishing between market driven vs. skill based returns

Long/Short strategy explained

The strategy compared to Long-only

By Evan Cooperman

April 8, 2005   

Last Month – A Quick Summary

Last month we took a look at hedge funds in general.  We established that the Alternative Investment industry is growing at a significant rate and that including hedge funds in your portfolio can enhance returns while reducing overall portfolio volatility. 

This Month – The Grand-Daddy

This month we take a look at a strategy commonly known as Equity Long/Short, or the Grand-Daddy of hedge strategies.  In fact, out of all assets invested in hedge strategies, long/short enjoys the lion’s share at an estimated 43%. 

Although you may think of hedge funds as a relatively new phenomenon, the long/short investment strategy has been in practical use for over 50 years.  The strategy originated in 1949 when Alfred Winslow Jones established the first US hedge fund.  Jones believed that performance depended more on stock selection than market direction and that he could build a fund that offered protection in a falling market.  He realized that merging the investment tools of short sales and leverage with long positions could yield a more conservative equity strategy than long positions alone.  

What does it mean to be long or short?  Investopedia.com (a great resource!) defines a long position as ‘The buying of a security such as a stock, commodity or currency, with the expectation that the asset will rise in value.’ A short position is defined as ‘The selling of a borrowed security, commodity or currency, with the expectation that the asset will fall in value’.  In other words, if you think a stock is going to go up, you buy it, or go long the stock and if you think the stock is going to go down then you short it.    

Key Concepts: Alpha & Beta (I knew I should have paid attention in class!)

The best way to understand alpha is by thinking of it as the part of returns that can be attributed to the manager’s stock selection skills (‘skill based returns’).  In short, alpha measures the ‘value added’ by a manager. 

Beta represents returns that are derived from market exposure (‘market based returns’).  If a stock has a beta of 1 it will move up and down in the same proportion as the market, if it has a beta of less than 1 it will be less volatile than the market and, finally, if it has a beta greater than 1 then it will be more volatile than the market.

The strategy explained

Long/Short can be divided into two major categories; Long/Short Equity and Equity Market Neutral.  This month we will focus on Long/Short Equity and we will look at Equity Market Neutral in a subsequent letter.  They key distinction between Long/Short Equity and Equity Market Neutral is that Equity Market Neutral attempts to eliminate all beta risk (market driven returns).

Long/short strategies combine both long and short equity positions.  The short positions can be used to generate alpha, hedge market risk and, finally, to earn a small amount of interest on the ‘short rebate’.  (Cash that is raised from shorting stocks is invested in T-Bills and the interest earned is called the short rebate – net of stock borrowing costs)  

Long/short equity funds come in different shapes and sizes.  Some managers maintain a net-long bias, some are net-short while others aim to be market neutral.  If a manager is net long or short then you still have market risk (beta exposure) because market moves will impact the portfolio.  If a manager is market neutral (zero beta) then market risk has been eliminated. 

Stock selection is the most important facet of this strategy.  Long/short managers analyze companies to determine their underlying value and go long stocks that are undervalued and short stocks are overvalued.  Successful choices will generate alpha.  

OK now you are well on your way to understanding the strategy.  We know that alpha is the ‘value-added’ by the manager and that good stock selection will generate alpha.  Most of the returns generated by typical long-only equity managers are market driven (beta-related).  Conversely long/short managers typically maintain lower net market (beta) exposure and, by virtue of combining long and short positions, are able to generate two alpha returns.  This doubling of alpha creates an opportunity to enhance skill based returns. (Don’t forget the potential to enhance losses as well!)  For this reason, when making an allocation to a long/short equity manager you must ensure that you are confident in the skills of the manager. 

Strategy example

Imagine that, after doing an in-depth analysis, you really like J&J because you think they are undervalued and have a blockbuster drug in their pipeline. 

You have two investment options.  Option A is to go long with 100% net market exposure and Option B is to go long and short with 50% net market exposure. (See table 1 below)   To implement Option B you go to your broker, borrow $25,000, and go long $125,000 worth of J&J stock.  Next you tell your broker that you would like to hedge some market risk by shorting $75,000 worth of the S&P500.  This means that, in simple terms, you have net market exposure of 50% (125% long – 75% short).  In terms of volatility, Option A has more risk because the higher market exposure generates greater volatility than Option B’s combination of leverage and shorts.

Now suppose that oil prices spike, causing the S&P500 to decline by 20% but since J&J was actually undervalued it only goes down by 10%.  (See table 2 below)  In the long-only scenario you would have lost $12,500 on your investment.  In the long/short scenario you would have lost $12,500 on J&J and made $15,000 on your S&P short for a net gain of $2,500.    The short position helped you to hedge some of the market risk and neutralize the negative market return.  Contrast this with a long-only investment in J&J that would have lost $12,500 and you can see why being long-only is like investing with one hand tied behind your back.

     Table 2: Hedging market risk with J&J example

Sounds good in theory but what about reality?

Do you remember what you were doing in 1990?  Probably, like most of us, you were spending many hours in front of the tube watching the debuts of Seinfeld and The Simpsons. When not watching TV, you may have been deciding on how to invest your hard earned cash.  Imagine if, at that time, you were choosing between investing all of your money in either the S&P500 or the HFR (Hedge Fund Research) Equity Hedge Index.  With the benefit of hindsight we can examine the following table to see the outcomes.

*Note on survivorship bias for HFR Index: returns may be somewhat overstated because data only includes surviving hedge funds and not hedge funds that went out of business.

If, from January 1990 to January 2005, you were long-only by being invested in the S&P500, your annualized return over this 15-year period you would have been a desirable 10.69%.  What if, instead of being long-only you had invested in the long/short HFR Equity Hedge Index?  In this case you would have had an even more desirable 17.47% annualized return AND much lower volatility.   Note HFR’s low market exposure as evidenced by the beta of 0.40 and the high level of skill based returns as evidenced by the alpha of 9.99%.  The basic fundamentals that Alfred Jones recognized back in 1949 are still valid today.  Modern day hedge funds have further developed the application of these fundamentals to achieve above average returns with lower risk.

Conclusion

Hedge fund managers use all of the investment tools available to manage risk and protect capital.  Long/short managers use longs, shorts and leverage as a great risk mitigation technique and hedging out market exposure helps to avoid negative compounding during market declines.  The importance of avoiding large negative returns (drawdowns) was not lost on either of the following two people:

‘An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.  Operations not meeting these requirements are speculative’ – Ben Graham

‘Compound interest is the eighth natural wonder of the world and the most powerful thing I have ever encountered’ – Albert Einstein

I concluded my newsletter last month by saying:

‘We firmly believe that with a properly designed, well implemented asset allocation, your portfolio should enjoy the benefits of participating in the upside of the markets while mitigating losses on the downside.’    

The Long/Short HFR Equity Hedge Index provides a perfect example of what I was talking about.  The worst 1 year return for the HFR Equity Hedge Index from January 1990 to January 2005 was -8.30% vs. -26.62% for the S&P500.  In fact, the HFR Equity Hedge Index captured almost 70% of the upside of the S&P500 but only 20% of the downside. 

Including Alternative Investment Strategies like Long/Short Equity in your portfolio will help to ensure that you have a portfolio built for all seasons so that you too can enjoy Absolute Returns.

Who says you can lose your shirt?

Next month we will be taking a look at Managed Futures, an investment strategy that is often misunderstood.  Managed Futures, especially when combined with hedge funds, really help to move portfolios into the Prime Quadrant! (Where risk is lower and returns are higher)  Tune in next month to find out how.

Note:

If you have requests or suggestions on subject matter for future e-letters I would greatly appreciate your letting me know.  If you do not wish to receive these emails in the future, please email ecooperman@primequad.com.  If this email has been forwarded to you and you would like to subscribe, please contact me at ecooperman@primequad.com

Past results are no guarantee of future performance.

This newsletter is for educational and informational purposes only and is not a solicitation to invest, and should not be construed as such.

Prime Quadrant LP^®

Your Financial Navigator™

Ian Rosmarin:               (416) 410-3648 x1

Evan Cooperman:         (416) 410-3648 x2

Louise Leong:               (416) 961-5556 x241

95 St. Clair Avenue West

Suite 1403

Toronto ON

M4V 1N6