Chapter Nine
A Field Guide to Hedge Funds, Part One
The Long and the Short of It
We once met a prosperous hedge fund manager and asked him the secret of his success. He told us that his method is to comb through the newspapers every day, and whenever he reads about a graduate of USC business school being promoted to CEO of a company, he shorts their stock. While this particular strategy is not widespread as far as we can determine, one of the key features that distinguish hedge funds from conventional investments is short selling. Most mutual funds constrain managers to buy only the stocks they think will go up. Then, under the Taxpayer Relief Act of 1997, the last restriction on short selling in mutual funds was removed, and the result was a spate of new investment products that let investors swing both ways.
This chapter is going to be about those hedge funds whose short selling is central to their strategy. As you have gathered by now, there is not just one type of hedge fund. In fact, there are 10 basic hedge fund types as handed down on the tablets from Dow Jones Credit Suisse. If you want to use somebody else’s classification scheme, be our guest. Our plan is to give you a primer on them here and then focus later on some specific mutual funds who run these strategies.
Long/short equity hedge fund strategies purchase securities that the managers believe will rise (the “long” part) in value while simultaneously shorting others that they believe will fall (the “short” part). Put them together and you have long/short equity. Sounds simple, doesn’t it? Well, it’s not.
What is Short Selling?
Many hedge fund strategies involve shorting stocks and other types of investments. Short selling means selling a security that you don’t own, but plan to deliver to a buyer in the future (after the price falls, you hope). In other words, you are betting the price will go down. This sounds un-American, but it is actually a vital part of price discovery. If only long purchases were allowed, the sole way you could express your opinion that the price of a stock is too high would be by standing on the sidelines. Short selling allows you to back your negative opinion with your wallet. Notice that this has the salubrious effect of not letting prices go unreasonably high. The market price represents the consensus of all buyers and sellers for any given security, unlike an auction where only the buyers have a voice.
That’s the theory, anyway. No doubt it can be abused when short sellers conspire to set up kill zones and bring their withering crossfire to bear on a single company, but that is a discussion for another occasion.
You short a stock by borrowing the shares you want to sell today from somebody who already owns them (a broker, typically) and then, when you want to close your position (cover your short), you buy the shares back on the open market after the price has—you hope—fallen and then you return the shares to their owner. You earn the difference between the cheap price you paid today to replace the stock you sold for the high price earlier (less the transaction expenses).
For example, let’s say you believe that the price of Apple Computer (AAPL) is headed for a fall. You borrow 100 shares of AAPL from your broker at $250 a share and sell them today for $25,000. Then, in a few months, everyone catches on to how overhyped Apple’s products are, and the price of AAPL falls to $100 a share. You buy the 100 shares back again for $10,000, return them to the broker, and keep the difference—$15,000—less whatever the broker charged you to rent them.
Easy money? Yes, especially if you’re right.
On the other hand, what if you’re wrong? Then it’s not so good.
When you are a long investor, all you can lose is what you initially paid for the company. If you paid $250 a share for Apple, and Apple simply disappears from the map, you are out $250, finis. Now imagine that you short Apple by selling 100 borrowed shares today for $25,000, and tomorrow morning Apple holds a press conference announcing that it has perfected the flying car, just like George Jetson used to drive. Ten minutes later, Apple stock rises to $10,000 a share. Your broker calls and says it needs the shares back. Now you have to buy the 100 shares you borrowed back for $1,000,000, leaving you with a loss (before expenses) of $975,000.
The bottom line:
- Long investing—the downside is limited and the upside is unlimited.
- Short investing—the upside is limited and the downside is unlimited.
You may be right about Apple stock being overhyped, but if you short it you can go broke waiting for other people to come to the same conclusion. Being right and early is simply another way of saying that you were wrong.
Being right and early is simply another way of being wrong.
The Long/Short Game Plan
Right away you can see how a fund that can go both long and short has the opportunity to do better than one that is long-only. Your standard mutual fund manager undoubtedly has all kinds of opinions about good and bad stocks, but he is only able to express these opinions by buying the good ones that he thinks are going up. The long-only mandate of most mutual funds ties his hands. To the extent that his opinions have value, he is leaving a lot on the table. However, most long/short hedge funds don’t operate so simply. It’s usually not a manager buying some stocks and shorting others.
Let’s assume the manager has no skill whatsoever. He’s just buying and shorting stocks by throwing darts. What will his performance look like?
He is likely to underperform in a rising stock market, since his shorts will drag him back. But he will outperform in a down market, since his random short positions will protect him somewhat from the general decline. If his judgment about the stocks is correct, he will do better, but this is the baseline performance curve he fights every day.
The problem is, there’s nothing very hedgy about this. His fund goes up when the market goes up, and down when the market goes down—just not as much either way. Institutions are not going to come rushing to hand this manager their money unless his track record is outstanding. He’s selling his performance, but his fund isn’t much of a stock market hedge.
What’s a long/short manager to do? Something more clever. He might buy small company stocks and short large company stocks. In fact, that is what the typical long/short manager actually does. Or, he might buy value stocks and short growth stocks. He might buy cyclicals and short staples. He might go long India and short China. It all depends on his area of expertise. All his bets could lie within a specific sector, such as technology or financials.
Keep in mind that the holding period for the securities might be measured in minutes. The long/short pairings might have been selected by a computer, based on some statistical properties of their prices. The computer might be buying recent losers and shorting recent winners and waiting for their prices to converge. This is called statistical arbitrage. The fund might be engaging in hundreds of these bets at any instant.
Another approach used by long/short managers is index arbitrage. As news hits the stock market, not all stocks react equally quickly. A manager could bet on the laggards to follow the leaders. Again, it wouldn’t matter if the stocks were going up or down; he could make money for his fund either way by going long or short depending on whether the news was good or bad. This is an extremely tricky proposition for the fleet of mind and execution.
Whatever he does, he can amplify all these trades by using leverage—either by borrowing money or by using options—contracts that allow you to buy or sell an asset at a prespecified price in the future—on these stocks. Options let him control a large number of shares for a small amount of money. If his bet pays off, the returns are magnified; if it does not, the options expire worthless and he moves on to his next idea.
The hedge fund manager doesn’t have to win them all. He just needs a small edge over chance, sufficiently levered to make a respectable profit. It helps to have high speed computers and to pay infinitesimal commissions. This is not something you can do by placing phone calls to your full-service broker.
Because shorting is such a fundamental idea to hedge funds, we had to go long on explanation. Our next ones will be short.
#2. Market Neutral Equity Funds
There are two cousins of the long/short approach that stand as hedge fund types in their own right. Long/short funds like those discussed above can be either net short or net long, depending on the views of the manager. Equity market neutral funds, on the other hand, take their long and short positions in stocks while conscientiously minimizing their exposure to the systemic risk of the stock market.
These funds practice relative-value fundamental arbitrage. In other words, they find pairs of stocks with a high correlation to each other and then go long the one they like and short the one they don’t. For example, let’s say our manager is an expert on the automotive business. He decides that Ford is a buy and GM is not. He buys Ford and shorts GM.
What’s interesting about this pair of trades is that the outcome will be unrelated to the stock market at large, and even unrelated to the performance of the automotive segment. The only thing that matters is whether he is right or wrong. If the market falls 1,000 points but Ford does better than GM, he’s made money on the trade and he’s a genius; if the stock market rises 1,000 points but Ford does worse than GM, he’s lost money and he’s a bum. With the stock market taken out of the picture, he is in a safer position to lever up his bet.
In the end, these managers will hold equal dollar weights of their long and short positions.
Market neutral equity funds can be designed to be neutral regarding currency weights, country weights, industry weights, market capitalization weights, or whatever neutrality is of interest. These funds are typically low risk, low return affairs, along the lines of conservative fixed income investments.
So, why would people obsess over this? Because of portfolio theory, which says that adding uncorrelated assets to your portfolio does you a lot more good than adding correlated assets. Most people pile on highly correlated assets (tech stocks, growth stocks, emerging market stocks, foreign stocks) and think they have a diversified portfolio, which they do, right up until the minute they don’t. Adding a market-neutral equity fund really diversifies, because it can make money in any economic environment if the manager can make the right calls.
Unlike the long/short funds and the market neutral funds, the dedicated short bias funds do just what the title suggests: They maintain a constant net short exposure. As a result, they will have a negative correlation to the rest of the stock market. For example, anybody who said the stock market was riding for a fall before 2008 was immediately crowned by the press as a far-sighted savant when the crisis hit—even if the reasoning behind their “the end is coming” pronouncement was totally specious. The few who actually did short the market that year made a killing for their investors. Because a dedicated short portfolio has by definition a high negative correlation to the rest of the stock market, these funds will do wonders for a portfolio so long as you can make money investing this way. In a bull market, though, that can be quite a challenge, as they rack up big losses year after year. The managers operate in the bizarro world where beauty is ugliness and everything is upside down. The occasional wins when the market corrects won’t be enough to make up for the gaping losses they sustain the rest of the time. We need to remind ourselves here that the long term direction of the stock market is up (it’s true). Betting constantly against the market has been a tough way to make money in the United States for the past 200 years.
Betting constantly against the market has been a tough way to make money in the United States for the past 200 years.
Therefore, these funds are better used to express your view that the world is coming to an end, or at least temporarily coming to an end. That kind of call is notoriously difficult to make, because it is really two calls: one to get out of the market and one to get back in, and both calls have to be timed correctly for it to work. Making the right call but getting the timing wrong equals making the wrong call.
Beware—dedicated short bias funds are not to be confused for even an instant with the inverse or leveraged inverse mutual funds and exchange-traded funds marketed to retail investors. Those funds attempt to do 100 percent (or sometimes 200 or 300 percent) of the inverse of some index, such as the S&P 500 index of large U.S. stocks. The problem is, because these funds target the daily price change of the index, it turns out that the series of daily price changes is not at all what you get or expect from, say, the inverse of the one-year price change. In some cases, the stock market can be down and your leveraged inverse fund can be down, too—exactly the opposite of what you expected. These funds work for day traders but few others (and, frankly, we doubt they work for day traders). There is even some question whether these finds might blow up if stressed by extreme circumstances. These funds are complicated, risky, and unnecessary for any but the highest of high fliers. Stay far away from these bad boys.
As the name implies, global macro managers take a 35,000-foot view of the world economy at a macro level and place their bets where they perceive imbalances, relative misvaluations, or other opportunities. With the whole world spread out before them like a land of dreams, they have a wide field to carry out their operations. They can make leveraged bets in equity markets, currency trades, interest rate futures, and commodities, in both developed and emerging markets worldwide. They are free to move wherever they perceive opportunity.
Many global macro managers have a quantitative approach, looking for prices that have moved far from equilibrium and seem poised to regress toward the mean, or for pairs of price movements that appear mispriced relative to each other and so create an exploitable gap. These funds keep especially alert to noneconomic factors, such as central bank policies or political maneuvering, which may distort prices. When something looks out of equilibrium and poised to correct, they pounce.
Perhaps the most common macro ploy is the carry trade popularized by Bruce Kovner, who used it as a virtual ATM to manufacture cash for his investors at Caxton Associates. The idea was that you borrow money from a country with low interest rates (say, yen from Japan), and then lend it at higher interest in another country (say, New Zealand bonds). The trick is that you don’t hedge the currency risk, you just rake in the difference between your borrowing cost and what you receive in interest. This works as long as New Zealand dollars don’t depreciate relative to the yen.
The most famous trade in global macro history was in 1992 when Stanley Druckenmiller and George Soros realized that the Bank of England did not have sufficient reserves to defend the British pound against devaluation but nevertheless would be stupid enough to try. Their Quantum fund proceeded to sell massive quantities of sterling. The net result was a $1 billion dollar transfer of wealth from British taxpayers to their fund’s shareholders, while Britain futilely tried to defend the pound. Not bad for a few days’ work.
Remember when all the other kids were smoking cigarettes and pressuring you to light up? Your parents probably told you that it’s a bad idea to go along with the crowd. But in the upside-down world of hedge funds, trend following is a good thing. If it weren’t for this bad advice from our parents, we might be rich hedge fund managers today. Trend following is extremely trendy in managed futures funds. Like long/short and arbitrage funds, managed futures go both long and short and use leverage. Managed futures are a bit like the commodities funds we discussed in Chapter Six. While a commodity index fund will passively buy and hold a basket of different commodities, managed futures are actively run by commodity trading advisors, or CTAs. These advisors typically have a proprietary system for trading in the futures markets, which include commodities but also trade currency, equity, and fixed income futures markets all over the world. There are over 100 liquid futures markets that can be traded within these asset classes. Some of these commodity trading advisors may be like Eddie Murphy in Trading Places, who follows his gut feelings about pork bellies, but more commonly traders use a trend following system to guide their buy and sell orders. Some would say “trend creating,” but that would be the subject for another book.
Trend following refers to the fact that investors love trends. When they see the market going up they pile in. When they see the market going down they stampede to the exits. It works best when things go from good to great or, interestingly, from bad to worse. It stutters when the market is choppy and directionless.
Note the “bad to worse” part. As hedge fund researchers William Fung and David Hsieh conclude in a 2004 paper, “Trend-following strategies thrive when conventional asset markets are distressed, which provides a valuable diversifying source of return to portfolios of conventional assets.” In 2008, when global equity prices were collapsing, managed futures were up sharply. But unlike, say, a dedicated short bias equity fund, they also can make money when the market is going up. Any trend, up or down, is their friend.
There is market psychology at work here. Investors are a notoriously anxious bunch and look for security by copying one another. This groupthink leads to momentum-driven, trend-creating events. The short-term voting machine of the market continuously undershoots and overshoots its long-term fair value.
The short-term voting machine of the market continuously undershoots and overshoots long-term fair value.
There are many ways to try to capture trends. For example, you might look at how prices have been moving for the past 10 days as a short-term indicator, the past 45 days as a medium-term indicator, and for the past 12 months as a long-term indicator. If all of these are moving up (or down), you might conclude that there is a strong trend operating and invest accordingly. If two of the three are moving up, you might conclude that there is a weak trend and take a smaller position, and so on. You can make the formula as simple or as complicated as you want. There is inevitably going to be a certain amount of backtesting and data mining of uncertain reliability and validity in these models.
Of equal importance are the rebalancing and bet-sizing risk management strategies that are superimposed over the trend following system. These managers have to periodically rebalance their portfolios to maintain exposure across each of the 100 or so markets in which they invest. This means that they don’t let the trends run forever, but eventually sell some of whatever has gone up to top off whatever has fallen below their baseline position size. In addition, they have to size their positions carefully, adding more weight where the trends appear strongest and placing smaller bets where the evidence is weaker. They don’t want to bet the farm on any one prediction, but patiently hope to make money across the totality of their transactions.
Does this really work? The evidence is that these strategies have been used to make money for futures traders since the 1960s. They even have a low correlation to ordinary commodities (0.18 to the Goldman Sachs Commodities Index) over this period. Managed futures have all the appearance of being a friend in times of trouble, the most welcome kind.
In the next chapter, we turn to funds where arbitrage is the principal strategy.