After working in finance for a while, you forget that you ever had to learn the basics. Which is ironic, because your own first year was devoted so earnestly to pretending that you understood what everyone around you was talking about. Along those lines, here are a few introductory notes on a particularly fundamental trading/investment strategy.
If you’re ever allocating money to hedge funds, then the first strategy to walk in your door will be a long-short equity fund. It’s the classic hedge fund strategy; in fact it’s the one the word “hedge fund” was coined to mean. The essence of it, as the fund manager will explain (with a distinct note of condescension), is that you form your portfolio by offsetting long and short trades, usually focused in a chosen sector or industry. The longs and shorts are exposed to the same general business factors, canceling out (hedging) all or most of the broad sectoral risks, which leaves just the company-level differences among them to determine your portfolio’s net performance. You know, if the oil price falls it will fall for the good oil companies just the same as for the bad ones. All the oil-company stocks go down, you lose money on your long positions, but you make much more than that on your short positions, because they go down more. You are positioned, theoretically, to benefit from the outperformance over time, in a succession of business environments, by the better companies (your long positions) versus the dogs that you hate and decided to sell short.
Except that markets have a funny ability to think of the one thing you missed. For instance, what if you decided to concentrate on buying the cheaper, higher-value, hidden-gem sort of companies, while selling short their overvalued peers. Good strategy, right? Except that the cheaper “value” companies are probably cheaper, at least in part, because they’re less well-known and hence less well-traded than the big overpriced household-name securities that you have decided to sell short. In effect, you are shorting liquidity.
That’s ok in a steady market, but if the market goes to hell in a hand-basket the first outcome is that illiquidity is punished. Bid-offer spreads, already wide for these hidden treasures, will now open up wider than the maw of hell, as literally every single buyer goes home, while sellers try urgently to hold up their pants. If you really need to sell one of your beloved illiquid long positions in the midst of a market crash, you will have to throw them at people and just hope that somebody accidentally keeps one. Those stocks may very well be unsellable at any price whatsoever. Meanwhile your short positions, overvalued as they were, will be hammered of course, but these better-known names will at least still be liquid enough for people to trade in and out of opportunistically, and so they will tend to retain some value. Your brilliant long-short strategy just inverted, and you lost on both ends. Your career, incidentally, is over.
That’s just one example of what can go wrong. It’s apparently so simple and obvious, but I have seen more than a couple of great fund managers busted precisely that way.
What happens in practice is that managers come up with all sorts of solutions to the challenge of how to balance their hedges. One manager’s solution will be to calculate all possible risks to the nth degree and combine them into an ideally nuanced diversification instrument; he will prove to you with statistics that he’s thought of everything. Hint: he hasn’t. But if somehow, against the odds, he really has done a superhuman job of balancing all risks, he has probably also offset every imaginable performance factor. He will sit there with 0.2% gain or loss every year until his last investor wanders off to commit suicide out of sheer boredom. Meanwhile another manager will boldly focus on sheer trading momentum to distinguish his longs and shorts. He will show you his Monte Carlo simulations, and probably a stack of technical charts to prove that his short positions have all been through a double-top, and the elliot waves are now conspiring in just the right directions; but of course he will have to redraw those charts soon enough, because the truth is that he’s just betting on trend continuation. Another manager will focus on forex exposure, another on rumored mergers, etc, etc. The only real limit is the human imagination, and each strategy can of course go wrong. It’s ultimately a matter of choosing your bets; and the real job is being aware of what they are and why you’re making them. I knew a really outstanding fund that based its net L/S exposures on the weather. They bought stocks that were going to benefit from expected weather patterns and shorted those expected to suffer. The manager was a finance whiz and a meteorology scientist. I haven’t looked into that fund for a while, but it was fabulously successful for a couple of years.