Traditional stock pickers live in a world that is analogous to Facebook. The average mutual fund manager spends their days buying stocks they “like”. For most, however, there is no “dislike” function. Like Facebook users, mutual fund managers are stuck in a one-dimensional world of “likes.”
Facebook doesn’t have a “dislike” button for good reason; they do not want to promote negativity. In the world of social media, we can understand why Mr. Zuckerberg has taken that stance. No such argument, however, exists in the world of finance. Active managers should be able to express “dislike” beyond simply not liking (not buying) a stock. Luckily, the investing toolkit does offer a “dislike” button and it is called “shorting.” This is the mechanism by which a manager can profit from a fall in the price of a stock.
The concept of being short a stock is very simple. When an active manager is short a stock they receive the inverse of the market return. So if a stock falls 5%, they make 5%; if the stock rises 5%, they lose 5%.
In active management, it makes absolutely no sense not to use the “dislike” button. If we trust an investment manager to identify “good” stocks, why wouldn’t we trust them to identify “bad” ones? Is the skill set fundamentally different?
In the one-dimensional realm of “likes,” managers only have half the opportunity to profit. In addition, as with Facebook, “liking” is an inherently optimistic expression. It is a bull market, growth-oriented strategy that relies on the stock market going up to make money.
The good news is, over long periods of time the stock market does go up. The bad news is, it does not go up in a straight line and can include significant periods of material loss. In a bear market, or recession, the ability to express “dislike” becomes even more critical. In periods like 2008, this action can make a huge difference to the fortunes of your portfolio.
In addition to being simple in concept, the actual mechanism for shorting is quite straightforward. The short seller borrows the stock for a period of time from current holders and immediately sells it, creating a cash position. The hope is that the stock price will subsequently drop, allowing the short seller to buy it back in the future at a lower price. If the same number of shares can be bought back at a lower price, there will be a net cash position from the trade. This is the short seller’s profit. What happens, however, if the price of the stock rises? The short seller is forced to buy the stock back at a higher price using his/her own cash reserves to supplement the difference (taking a loss).
Why do stock holders lend the stock? Because short sellers pay them for doing so. The short seller has to pay a rental fee during the loan. For long-term, institutional stock holders who are relying solely on the premise that the stock market rises over time, stock lending can boost returns.
Our like/dislike equity strategy opens the door to a very powerful concept – that of modified beta. To explain this idea we have to make a short detour to discuss the definition of beta.
Beta is a statistical measure; it measures the variability, or movement, of a security in relation to the whole market of which it is part. It is also a term that can be used interchangeably with market. In this context the beta is the asset class; it is the collective personality of an entire market by which all participants’ behavior can be, to some degree, explained. Statistically speaking, it is the independent variable.
The stock market has a personality; there are the factors that drive its return, such as earnings growth, dividends and price earnings ratio. It also has a statistical personality; we understand that the stock market has expectations for return, variability, and worse losses along the way.
It is this personality that shorting stocks can change; we can reduce the variability and maximum capital losses, while trying to maintain the expectation for long-term return. Put another way, we can modify the beta. At best, we might actually create a better personality. At worst, we have created another personality type that might be utilized in a way the original personality was not.
Our modified beta is a considerably less excitable version of the original, and that makes its inclusion appropriate where it previously might not have been. Traditionally, advisers rotate investors away from equity towards income-generating bonds as they approach retirement. This is because once the nest egg has been built, the material draw downs of the equity market, which are very damaging to income objectives, become unpalatable. That makes sense to some degree, but in giving up on the equity market we release a powerful and diversifying source of real return. We may also be facing a bond market with negative real yields. Our like/dislike equity strategy allows us to maintain exposure to equity for longer, and/or keep a larger allocation. That is a very useful tool to have at our disposal.
In fact, through shorting, equity risk can be modified to the point where its risk and return characteristics look more like those of bonds. When a manager has as much short exposure as long exposure, we refer to them as market neutral. The overall direction of the market should no longer dictate the return. Instead, the return is solely the product of the price movement differential (spread) between the collective long positions and the collective short positions.
Why would we want to replicate a bond-like strategy using equities? Because while the statistical qualities might be similar, the return drivers are not. There is no credit risk in our long short equity market neutral strategy, nor is there the same interest rate risk or structure risk. When the bond market loses money due to one of these risks, our market neutral equity strategy will not.
The dislike function facilitates two powerful transformations that are literally investment management game-changers. First, we can hold the return drivers of an asset classes steady and change the statistical risk/return characteristics. Second, we can hold the statistical risk/return characteristics stable and change the return drivers. In the next chapter we will once again visit modified beta and further develop this concept.
While we have discovered an exciting new tool, our like/dislike equity strategy is not a slam dunk and there are challenges. First, shorting has a natural long-term headwind, which is the premium for bearing equity risk. Despite the ups and downs, buying the equity market has historically proven to be a very successful investing strategy for those with a long-term time horizon. A large diversified basket of stocks, when left for 20 years, has a very good chance of making real money.
The reverse would be true of shorting a diversified basket of stocks. By receiving the inverse return one would expect to lose money, receiving the opposite of the equity risk premium. We don’t have to get our long stock positions exactly right to make money. They might underperform the market, but there is a good chance they will still make money. The same cannot be said for shorting.
Dividends are another material headache in the world of shorting. As described, shorting a stock involves borrowing it from another investor and immediately selling it, hoping to buy it back at a lower price in the future. The stock lender is still expecting to receive their dividend and the short seller has to deliver this. As dividends represent a significant part of the overall return of equities, this is another significant headwind to the success of shorting over long periods of time.
Shorting also carries basis risk. While a very strong argument can be made that shorting stock reduces risk, it can also magnify loss. This occurs when the short position and long position both lose money at the same time. Imagine a day when the market in aggregate falls. Long positions lose money as expected, but the short positions, for idiosyncratic reasons, actually go up in value (and being short, we receive the inverse). That translates into a levered loss as both the long and short positions lose money.
The final technical detail we will mention for this strategy is called the short rebate and it can be a tailwind or a headwind. When a borrowed security is sold, the short seller receives cash. This cash generates interest and when short-term interest rates are high, the interest can offset dividend and rental costs. However, when short-term interest rates are low, it does not. The short rebate has been a headwind in recent years as short term interest rates have been stuck at zero.
The picture we are building here is that there is an element of long short equity that is risk reduction, but there is also an element that is risk swapping; we are swapping one type of risk (market risk) for another (idiosyncratic risk). This is a principle that permeates the entire liquid alternative investment landscape. In addition, alternative investments often incur added expenses – the cost of executing the strategy.
Just like the asset classes they trade, many alternative investment strategies encompass some degree of cyclicality in their returns. It is important, therefore, to be able to identify the health of the structural underpinnings of a strategy. While not something any investor should want to pay active management fees for, it is an inescapable fact that sometimes a material part of the strategies performance is directly attributable to the performance of one or more embedded betas. However, beta is usually just one piece of a more complex return equation.
There are times when equity long/short works really well and there are times when it doesn’t. After the credit crisis, equity long/short managers struggled for a few years. Quantitative easing reflated the stock market, but it did so in a somewhat artificial manner. Correlations between individual stocks rose as the share prices of both good and bad companies ascended in unison. High correlations with a lack of dispersion between individual share prices made a stock picker’s life very difficult.
In fact, there were many times during the post-crisis stock market recovery that junk stocks outperformed high-quality stocks (by common valuation and quality metrics). This was because the price moves were predominantly liquidity driven as opposed to fundamentally driven. Junk rallies are a particular headache for long short managers because these are the very companies they are betting against. Quantitative easing therefore drove an ugly form of basis risk as the short positions outperformed the long positions on a relative basis. In addition to this headwind, managers faced a backdrop of zero short-term interest rates (no short rebate), financing costs of leverage and expensive stock borrow rates. Managers also had to make dividend payments on short positions. This environment created pretty unfavorable waters for equity long/short sailing.
Finally, when a strategy involves an anomaly, which many hedge fund strategies do, capital flows are a critical factor. As money flows in, opportunities and risk premiums inevitably shrink as consequences of crowding. The strategy then starts to perform badly and money flows back out, once again expanding the risk premiums. This is one reason that rebalancing is important when dealing with alternative investment strategies.
The concept of dislike is not explicitly tied to stocks. As described, being short is accepting the opposite/inverse of a return. Our like/dislike equity strategy could actually be applied to anything. The security could be a stock or bond. Any beta can be modified; the risk characteristics of any asset class can be changed.
The like or dislike does not have to be an individual company either. The concept can be applied to an index. So if we decide we like the U.S. but dislike the U.K. we could buy the S&P 500 and sell short the FTSE 100. Entire commodity and currency markets can also be traded long and short.
Like and dislike can also become like or dislike. Shorting paves the way for more sophisticated directional macro trading. For any market we can now be in it, out of it, or bet directly against it. With shorting at our disposal, the market timing toolkit is complete. Tactical asset allocation can go beyond market exposure tilts and actually metamorphosize into an orthogonal trading strategy in its own right.
Extending Modified Beta
While we are tackling the concept of modified beta, this is the appropriate moment to expand the definition a little further. While our like/dislike equity strategy can be bent to the point where it exhibits zero or even negative correlation to the broad equity market, it is perhaps more commonplace to maintain some market exposure or beta.
In a broader sense, modified beta can be used to describe any hedge fund trading strategy that exhibits material beta to a major asset class. Event-driven credit strategies would be one such example. As described in Chapter 1, distressed investing involves buying the heavily discounted securities, often bonds, of companies that are close to announcing or have announced Chapter 11 bankruptcy. The manager holds the securities, which are eventually exchanged for securities, often stock, in the new post-reorg company. The manager may or may not be actively involved in the restructuring process. The fund makes money if the post-reorg stock position is worth more than the purchase price of the discounted bonds.
The manager may go through the entire restructuring with no hedge or downside protection in place. As a consequence the return stream is highly correlated to risky credit and equities. Distressed investing is often invested in as part of an allocation to high yield. While the deeply discounted bonds and Chapter 11 process leave plenty of room for alpha (outperformance), the strategy can be thought of as a modified beta.
We think even Mr. Zuckerberg would agree that active managers should be able to express “dislike”. Our like/dislike equity strategy has opened a whole new world of risk and return textures that were not previously available. In the traditional investing paradigm, equity exposure is slowly eradicated because the need for capital preservation becomes paramount. Long short equity strategies allow investors to have their cake and eat it, because they provide long-term capital growth without compromising capital preservation.
Like/dislike equity is actually just one branch of like/dislike anything, where anything can be any security. The security could be from an individual company or represent an entire market. The dislike function involves any trade that delivers the inverse of the securities return. Finally, the idea of shorting extends beyond reducing the risk of an asset class. It opens the door to market timing alpha. Here we segue into unconstrained global macro strategies and are now ready to explore asset class androids – the subject of our next Chapter.
John Shearman, CAIA, is the CEO of IV Lions LLC. For the past nine years, John was a partner at the world’s premier alternative investment advisory firm, Albourne Partners where he advised sophisticated investors on alternative investments. Prior to that, John was a senior analyst/developer at Goldman Sachs in London. He began his career as a management consultant in the financial services sector at PricewaterhouseCoopers in London. John also holds the Chartered Alternative Investment Analyst designation. John has authored two books: Foundations of Investing and Liquid Alts (http://www.amazon.com/dp/B00NULPMCW). He is often quoted in the financial press and has been a speaker at numerous events including those held by The Institute for Private Investors, Institutional Investor, [California] State Association of County Retirement Systems, and the Northwest Hedge Fund Society.