In principle, it all sounds easy enough. You've had a number
of years in the business of traditional "long only"
fund management. You've honed your ability to pick winners
from the crowded, noisy universe of stocks, and you're feeling
constrained by your inability to short the losers, and also
by that ubiquitous foil to performance - the Index. So you
decide to take that brave leap from the "relative"
to the "absolute" space. This is a place where freedom
and creativity reign supreme. Congratulations, you've just
left the frying pan. Hopefully you aren't entering the blast
The purpose of a long / short equity hedge fund is to provide
absolute returns by investing in stocks with superior return
characteristics, and by disinvesting in or "shorting"
stocks with inferior return profiles. Typically, these funds
will also show some bias to the long or short side - based
either on the strength of the manager's conviction in his
positions, or on a market view.
The challenge in running such a portfolio is in balancing
the return profiles. Put simply, there are three potential
outcomes. The most favourable outcome is when long positions
rise in value and short positions decline - known as "double
alpha." Another outcome is when one side of the portfolio
- either the long or the short book - moves favourably and
to a value in excess of the other book. This is called "single
alpha." The third potential outcome is when both sides
of the portfolio move against the manager - the shorts increase
in value, and the longs decline. We refer to this in hushed
tones as "double splat." Obviously the manager attempts
to generate double alpha wherever possible, but at the least
he will strive to secure single alpha, with the opposing position
constituting a hedge.
The manager has a number of ways in which to deploy capital.
One method is known as a "pair" or "relative
value" trade. In this case, a manager will select two
stocks, for thematic or quantitative reasons, that currently
or historically display a strong correlation. Should the stocks
deviate from this relationship, a manager can open long and
short positions, seeking to profit as they revert. The key
is ensuring that in fact there is a demonstrable reason for
Another approach is to open short and long positions that
are not necessarily connected by a theme, but in such a way
that the overall portfolio's sectoral exposure and beta value
are appropriately matched. Depending on the manager's appetite
(and mandate) for risk, this may result in an intentional
overweighting or "bias" toward the long or short
Finally, a manager may choose to take an unhedged position,
based upon his conviction. Such "naked" positions
require stringent risk management procedures, but can be highly
rewarding to the portfolio.
Running a short book can feel unnatural and disquieting for
many beginners. The spectre of unlimited losses can undermine
even the most robust arguments if the market moves against
the manager. Managers may be emotionally motivated to ride
their losses into oblivion, or to close the positions too
soon, generating cost for the portfolio without receiving
the benefit of the research into the company. In order to
mitigate this risk, it is highly advisable to put in place
firm limits to gross and net exposures for the overall portfolio,
and to limit the size or value of each position within the
portfolio. Adhering to these limits without question will
reduce the volatility of the portfolio over time. Please always
recall that that your portfolio is someone else's
investment. No one wants excessive volatility in investments,
unless they happen to own an antacid business!
Another important consideration in running a long/short strategy
is the scalability of your strategy. Those managers who have
enjoyed success in their funds are occasionally seduced by
the prospect of increasing their capital base by taking new
subscriptions. However, market liquidity (particularly in
the short book) may dictate that the fund can reach a size
at which it is difficult or impossible to exploit certain
investment opportunities. At best, growing too large may impede
optimal performance. At worst, it could lead to "style
drift" (when a manager departs from his stated investment
style) - which will undoubtedly upset the end investor.
Leverage is an often misinterpreted word, with negative connotations
attached. Using leverage will, in some investors' minds, conjure
images of "cowboys" taking outsized bets, looking
for that "killer" return. To my mind, leverage is
not necessarily an evil. Rather, it is a tool that, under
controlled circumstances, may be employed to increase overall
exposure to a portfolio stocked (if you'll excuse the pun)
with good ideas. Investors can be persuaded of the benefits
of getting "more bang for their buck" if the intent
to leverage is fully disclosed and subsequently managed in
compliance with the stated objectives and the return target
of the portfolio.
Finally, the long/short model implies that the manager must
be somewhat opportunistic in his approach to investing. Properly-timed
entry and exit of positions, and by extension understanding
the market's movement, can become a significant contributor
to alpha generation. However, the manager must be careful
not to let his attention wander from the strategy to the screen.
A balance must be struck between attention and distraction.
Long/short investing is particularly effective in large,
liquid markets, with good trading access and where corporate
disclosure is perhaps not optimal. This allows the fundamentally
driven long/short manager to derive advantage through a thorough
investigation of the company or companies in question. The
momentum or trading-driven long/short manager will also be
advantaged, profiting from volatility.
Managing all the aspects of the long/short model is challenging,
and the investor knows this. The investor accepts risk, but
needs to feel that the manager is comfortable in his ability
to identify and mitigate the risks inherent to this strategy.
Thus, a manager can greatly assuage any investor concerns
by offering a clear articulation of how he intends to balance
each of the aforementioned elements. In turn, the ability
to offer this explanation entails a thorough consideration
of all the relevant issues.