Newly popular long-short
Long-short investing strategies aren’t just for hedge funds anymore.
Many investors believed diversified “long-only” portfolios would always serve them
well, regardless of the market conditions. They expected certain asset classes would perform well even as others
After all, most mutual funds, exchange-traded funds (ETFs) and managed
accounts offer long-only strategies. And why not? After all, the strategy is simple: These portfolio managers
buy securities and hope to take advantage of price appreciation.
But the ongoing financial crisis proved those investors wrong – for several
reasons. After all, what do you do in a trendless (sideways) market? And what about a declining market?
In either situation, the profit payoff from a purely long portfolio doesn’t figure
to be very large. And that’s no surprise. After all, when bear markets arrive – as they periodically do – long-only
money managers are typically limited to raising additional cash, or seeking conservative investments with limited
downside, meaning the upside potential is also fairly small. And as investors have seen all too often during the
current financial crisis, money managers who insist on “fighting the tape” can often generate big losses for their
Long-short investing strategies help portfolio
That’s where long-short investing strategies come into
play.If the markets head up or down, you’re positioned to profit. And given
the wild volatility we’ve witnessed in the last year, any investor not playing both sides of the market,
simultaneously, quite frankly, deserves it if they drown their portfolio.”
Unfortunately, many investors have learned their lessons the hard way for the past
year and a half as virtually all classes have declined in value, resulting in sizable losses within their
“This environment has exposed the flaws in traditional asset
allocation theory, Capital Asset Pricing Model (CAPM), or whatever label you choose to put on it,” said Tom Samuels, managing partner of Houston-based
Palantir Capital Management Ltd. and manager of
the Palantir Fund, a global all-cap
long-short mutual fund. “While Markowitz (Harry) and Sharpe (William) still have their firm believers, sophisticated investors are realizing that they
cannot achieve true diversification merely by being long a variety of asset classes.”
Samuels believes the majority of long-only returns are influenced by the direction
of the overall markets and that long-short investing strategies provide one of the few ways to achieve true
portfolio diversification and risk control.
“Long-short represents the only asset class that can effectively handle both
sideways and bear markets,” Samuels said. “The asset class allows investors an opportunity to systematically
approach the markets and individual risk parameters differently than being long-only.”
The Long and the Short of a Newly Popular Investing
A long-short money manager has the ability to both buy and sell stocks to help
reduce risk during such less-than-optimal investment environments as a trendless market or even a bear
The long-short strategy often serves as a hedge from overly bearish markets by
allowing investors to take advantage of upside potential (long positions), while also benefiting from downward
movements of certain investments (short positions). In choppy markets – like those of today – the strategy can help
investors book some gains as they focus more on capital preservation, and not simply appreciation.
In reality, investors should consider incorporating some form of a long-short
approach as part of the overall asset allocation of their portfolios, experts say.
Brian Lipton, founder of Gaithersburg, Md.-based YellowWood Financial Advisors Inc., seeks out investments that
are not correlated with traditional
stocks and bonds. Lipton views long-short investment products as another piece to the portfolio construction
puzzle, and has incorporated hedged equity mutual funds as part of a tactical allocation – a way of reducing
exposure to the risk of a long-only securities position.
“We realized long ago that we cannot ‘time’ the markets,” said Lipton. “We
typically allocate about 20% to 30% of our equity portfolios in a tactical manner. Hedged equity represents a part
of that allocation that helps satisfy certain risk elements and, of course, allocations that reduce long-only
exposure in this environment have been beneficial. We have found that hedged mutual funds have been a very good
choice during periods of intense volatility and could work well during other times as well.
Lipton’s firm uses one fund that goes long on favored positions, short on
out-of-favor positions, and another fund that buys equities and hedges them with short positions on various
“While the latter fund is 100% hedged today, that percentage could change based on
their views of the market environment,” Lipton said. “Security selection is still important.”
Hedging Plays: Make Macro Calls, Dodge Market Falls
At Palantir, Samuels looks for opportunities to hedge long positions, while also
seeking profits on the short side. In managing his long-short fund, Samuels will make macro calls on the markets
and the economy, micro calls on companies he believes to be either under- or overvalued, and also employs
market-neutral arbitrage trades by pairing long and short positions in similar securities.
“Right now, we are short the dollar by owning the [PowerShares DB U.S. Dollar
Bearish Fund (UDN)], an unlevered ETF that inversely mimics the movements of the U.S. currency,” said Samuels.
“That position represents a macro call against the dollar and the ETF shot up dramatically when the Fed announced
its intent to aggressively buy Treasuries to lower rates. Additionally, we believe this short trade provides nice
cover as some domestic companies may struggle relative to their international counterparts.”
Samuels’ fund is also betting against U.S. Treasuries through short positions in an
ETF that tracks long-term government securities.
“Historically, central banks have had mixed records of holding rates down,
particularly when their currencies begin to fade,” Samuels said. “Shorting Treasuries provides an opportunity to
make money on that macro call, while also serving as a hedge against certain long industrial and consumer-related
domestic equities that may struggle in a rising interest rate environment.”
Dave Walker, YellowWood’s director of operations, points out that his firm has
begun using a long-short commodities-based fund as a way of employing this non-traditional investment
“We have been allocating a portion of certain clients’ portfolios into long-only
commodities funds for years, but gains and losses have recently come so fast and furious that we chose to move into
a hedged product,” Walker said. “We realize we cannot time these markets on a daily basis by investing long or
short. But based upon the trends in the global economy and surrounding specific categories of commodities, a hedged
commodities fund allows us to participate in this alternative asset with lower risk and volatility. We will trail
indices when there is a quick rebound but, more importantly, we expect to curb the downside.”
Market Neutral Pairs
Palantir’s Samuels explains the pairs trading concept through a hypothetical
“The market-neutral pair trades entail buying a company in a high-quality security
as measured by free cash flow (FCF), low debt, and [solid] profitability, and simultaneously selling a
security in the same sector that we perceive to be [of a] lower quality based on these same parameters,” Samuels
said. “Let’s say, we liked Intel (INTC)
because of where the company is in its product cycle, its low debt position, and its positive cash flow.
Conversely, we recognized that [Advanced Micro Devices (AMD)] maintains considerable debt and its last product
introduction was under whelming. In this example, we may choose to go long Intel and short AMD.”
Samuels then discusses an environment that has the overall equity market declining
by 30%, with Intel and AMD dropping 25% and 35% respectively.
“A properly executed paired trade would have returned 10% to the investor, even as
the stock market as a whole lost 30%,” said Samuels. “The long-short manager then has the opportunity to unwind the
arbitrage, but only one side at a time, if desired. We may believe AMD is more fairly valued after a drop of 35%
and choose to cover our short, while still owning Intel, a high-quality stock that could appreciate should the
market rebound. The long-short approach provides us significant flexibility, while the long-only manager has to
identify high-quality stocks and then hope that the overall market direction cooperates.”
YellowWood’s Lipton had not seen sheer panic from his clients – at least not before
the Dow Jones Industrial Average recently fell below the 7,000 level.
“For the most part, our clients understand their allocations and we received very
few distress calls,” said Lipton. “Nevertheless, we know the concern is there. When the Dow broke below 7,000, some
became worried about further significant slides without any apparent market support. We spoke with them more about
increasing the hedged positions and they were happy to control the downside better, while giving up a bit of
appreciation potential. They were very interested in such investments, particularly given the uncertain environment
we are in.”
And these days, a little peace of mind can go a long way.