The long and short of hedge funds

PORTFOLIO POINT: A long/short hedge fund can offset market risk, but research is vital in selecting a fund with the best structure and strategy to suit your risk profile.

In recent articles I looked at the overall hedge fund landscape from a variety of perspectives including performance and risk, as well as considering the wide diversity of strategies that combine to form the hedge fund or absolute return sector.

What became abundantly clear is that there is no such thing as an average hedge fund, with differing underlying assets such as equities, commodities, FX and fixed income, and vastly different investment styles even between funds and managers following the same strategy.

In this article I focus on the various strategies that collectively use “equity long/short” as the core component driving performance and risk. Whilst all of them use a degree of short exposure to either hedge out risk or increase market exposure to a greater or lesser degree, the difference between each is significant, as are the skills and therefore the performances of the managers involved.

Firstly however, a basic understanding of short selling – both the reasoning behind it, the mechanics and some of the terminology used – is required to understand how various versions of long/short work in practice.

For the sake of this article I won’t enter into a debate on the rights and wrongs of short selling. As for the logic or strategy of short selling, in negative markets such as those we’re experiencing at present, not being able to “short” is akin to skiing uphill, or sailing across the Tasman without a life jacket. The first is difficult at best, or impossible if the slope is steep enough, and the latter simply foolhardy.

Making a profit when buying a stock is simple in theory: Buy low, and then sell high. Shorting is the same but in a different order: Sell high, and then buy low.

As we all now know, markets don’t always travel in one direction, and within a market some stocks perform better than others.

The essence of short selling therefore is to benefit when markets or individual stock prices are falling. In practice this might be done as protection (hence the “hedge” in hedge fund) of an overall portfolio, or to profit from individual stocks which are considered overpriced. The objective therefore, and the challenge for the hedge fund manager, is to buy (or go long) the stocks that are expected to rise, and sell (or go short) those that are overpriced and expected to fall.

In practice, in order to short, or sell first, the manager has to “borrow” stock from a long-term holder with the requirement to deliver it back to the lender when the position is re-purchased and closed out. This is done through the fund manager’s “prime broker”, who in simple terms acts as the middle man between borrower and lender.

Of course shorting is not as simple as that, with a range of risks and complexities which can come into play, not the least of which is that the stock may rise instead of fall. This provides the greatest risk, because in theory at least the potential maximum upside to a stock price is unlimited, while the potential downside is no more than the price paid for it. However, other risks include the availability and cost of borrowing the stock, the lender wanting the stock returned, and corporate events such as placements or new issues.

Varied exposures
Drilling down into the various styles of equity long/short strategies, the majority of hedge funds in Australia vary in the level of market exposure in their portfolio, although there are also variations in their style and implementation. Market exposure can be measured in a number of ways, and as a benchmark let’s consider the traditional “long-only” portfolio. Assuming it is fully invested and holding no cash, this portfolio is 100% exposed to the market even if it is weighted differently to various sectors.

One of the benefits of long/short investing is that by taking short positions the fund receives the cash proceeds of the sale which can then be reinvested into long positions, creating a degree of leverage. For instance, if they have $100 to invest they might short sell $30 worth of stocks, allowing them to buy $130 for the long portfolio. In this example the gross market exposure is 160% (130% long, plus 30% short) while the net exposure remains 100% (130% long, minus 30% short).

This can vary dramatically depending on the fund’s investment mandate. Depending on the manager’s view, exposure can be dialled up to increase leverage to the market, or reduced if they perceive excessive risk.

Understanding the gross and net exposure levels a manager takes is important to the investor as it forms one of the key differences between the various long/short strategies, some of which have specific market exposure levels. As a result, these differing strategies can be expected to perform differently under different market conditions.

The majority of long/short funds have variable gross and net exposure levels, generally within specified risk limits. For instance for each $100 invested a manager might short $100 worth of stocks, enabling them to buy a total of $200 worth of long positions. Gross exposure would be 300%, and net 100%, but the gross position would have provided 200% leverage. As many investors are now aware, leverage can act as a double-edged sword, increasing positive performance but also increasing risk.

In current market conditions many risk-averse managers have reduced their net market exposure thereby avoiding leverage, and also the potential for large losses if the market falls further. Indeed, it is one of the most important benefits of long/short strategies that allow the manager to dial market exposure (and therefore risk) up or down subject to their view of the market.

130/30 and Market Neutral
Other strategies have fixed, or limited exposure levels. The best known of these are 130/30 and Market Neutral. Both are long/short strategies but, as the name suggests, “130/30” allows the manager to short 30% of their available funds, and with the proceeds increase their long exposure to 130%.

130/30 funds have seen a significant increase in numbers over the past few years (with variations such as 120/20 and 150/50) as investors have become aware that traditional long-only investing can create significant risks. From a performance perspective the success of these has varied considerably. In rising markets, the increased exposure has provided improved returns, while in falling markets being 130% long has resulted in increased losses, which the 30% short exposure has not been sufficient to overcome.

A further issue for investors attracted to the concept of 130/30 strategies is they have increasingly been adopted by traditional long-only fund managers whose skills and experience have been focused on buying stocks. What has become very apparent is that the skills and experience required for short-selling or managing a long/short portfolio are quite different.

The chart below shows the cumulative performance of various long-short strategies against the ASX200 since January 2008:

While it clearly shows that they have all out performed the ASX200, there has also been a significant difference between the strategies themselves, with Market Neutral clearly avoiding the volatility of both the market and 130/30, and to a lesser degree the general or variable exposure long short style.

Some caution should be used in extrapolating this data however, as there are only a limited number of 130/30 and Market Neutral funds in the sample data. As a result the influence of individual fund performances can distort the overall picture.

Market Neutral strategies are different again, aiming to have balanced long and short portfolios – buying and selling stocks in equal proportions. In theory at least these funds have no net market exposure, but in practice that is not the case as the performance depends on the ability of the manager to select which stocks to buy, and which to sell.

Within the Market Neutral basket there are a variety of styles including “Pairs Trading”, in which the manager will match stocks from the same sector such as banking or retail. In this environment it is the relative performance of each stock in the pair which determines the profit. For example, consider two banks, A and B, each trading at $20 per share, of which A is expected to perform better than B.

In this case the Market Neutral manager buys one share in Bank A, selling one share in Bank B. A number of things can then happen:

If Bank A rises to $21 and Bank B falls to $19, the trade makes $2 or 10% on the net exposure of $20. This is obviously the best and desired outcome.

Even if Bank A falls to $19 there is still the potential to profit, provided Bank B falls below $19. The same happens if both rise, provided the price of Bank A outperforms Bank B.

However, nothing is foolproof: If Bank B rises, and A falls, or if Bank B outperforms A, then the trade as a whole loses money.

Not all Market Neutral managers use the “pairs” strategy, but it provides a good example of taking limited market risk even though individual stock risk remains.

To sum up, all three strategies, while all applying the use of short selling, use it to a greater or lesser degree to either increase or decrease their overall market exposure, with the result that the industry and investors tend to differentiate between them.

Undoubtedly 130/30 exposure tends to perform better in rising markets and suffer in times of volatility:

Variable long and short exposure provides a flexible net market exposure, but this can vary from manager to manager, so the resulting performance can vary dramatically as well:

Market Neutral is balanced between long and short, but doesn’t guarantee either market performance, or limited risk.

Reducing market exposure is no guarantee of avoiding losses. Stock selection is still vital.

Having decided that long/short can provide some level of protection in negative markets, the challenge remains the selection of the right strategy and the right manager to invest with. Careful manager selection is the key as the variance between individual fund performances, even within the same strategy, can be dramatic.

Chris Gosselin is chief executive officer of Australian Fund Monitors Pty Ltd. www.fundmonitors.com