Trade in Groups

Looking through Morningstar mutual fund data the other day, I was struck by the fact that every single US stock fund in their 10,093 fund universe had posted a negative return year-to-date. While eight funds had posted “only” single-digit percent losses, not one fund had a positive return – think about that for a moment.

Whether you believe the market is cheap and poised to rally, or due for more pain, it’s clear that long-only investors are at a serious disadvantage when the broad markets are falling. Now, most mutual fund managers have allocation rules they must follow, but as an individual investor, no such constraints exist. 

Think back just 18 months to the spring of 2007: hedge funds scouring the world and using all sorts of “alpha” strategies to drive “absolute returns” were all the rage. Fast forward to the present, and revelations that the risk management at some top funds wasn’t as good as advertised (even Citadel, Tudor, and SAC have supposedly been dented), and in some other cases the money wasn’t even there (oh, Bernie Madoff), have killed enthusiasm for absolute return strategies. But the underperformance from a number of hedge funds does not mean the value of absolute return strategies is dead, just that the particulars need to be adjusted to have a strategy that truly generates alpha.

As much as individual investors might believe hedge fund techniques are too complicated, there are practices they use which can be implemented even in small portfolios. As much as hedge funds have captured attention for their eye-poppingly high returns in previous years, a true hedge fund emphasizes the hedging of risks. Proper hedging has a cost and may mean slight underperformance in bull markets, but it can save a portfolio when things go wrong. Is that trade-off worthwhile? I imagine nearly all long-only traders would like smaller but more consistent absolute returns right now. 

One way to target absolute returns is through pairing long trades with short trades in correlated assets. The objective is to buy the relatively undervalued asset while selling short the relatively overvalued asset, and the benefit is that while a single direction bet (i.e., one long position) is vulnerable to a broad move in the markets, having both a long position and a short position helps to hedge that risk.

An example discussed on this site in mid-June involved oil stocks, and why it was/is better to play oil by being long the E&P majors while being short the much-hyped oil service companies. Despite all the turmoil in the second half of the year, that turned out to be a great trade overall. The trade returned about 12% in six months, a significant amount considering this was a long/short hedged trade AND the S&P 500 was down over 35% in the same time.

Of course, if you were only long the E&P majors, the same can’t be said. This is why having an off-setting short position is so valuable… 

Because as the chart showing the performance of the oil service short so clearly demonstrates, this trade was a winner because the short fell much more than the long.  

Now, a final word of caution: there is no free lunch in the markets. Shorting is difficult, and long/short strategies have risks, just like all investments.

Even so, adding short-selling to one’s toolkit of strategies is an excellent starting point for pursuing alpha – that is, consistent positive returns, regardless of market conditions.