Saturday, March 7, 2015

Long short & the myth of market neutrality

“The market can stay irrational far longer than you can stay solvent”
-      John Maynard Keynes

Long short strategies when right can produce wonderful returns as well but the risk associated with these is far higher than you think. On paper these strategies look wonderful. Imagine if you can make the market return without the downside because your longs and shorts offset each other. Many funds claim to be market neutral but in reality they have massive amounts of implicitly leverage. When you short a stock the most you can make is 100% but the most you can lose is infinite.

Shorting also creates bad karma as Guy Spier very aptly puts it in his book. Thinking about negative elements attracts you to negative actions. Think about a company that is trading at 3x its intrinsic value. Now imagine that if it grows at 20% the value will catch up with your shorted price very rapidly. In 6 years it is like to be at that value. How do you know that in this 6 year period the stock will fall? Many would make the argument that a short position is a positive carry trade – which means you get paid interest on the money you receive when you short a stock but that carry by no means pays for the risk of the short position.

Other might make the argument that you can short using equity swaps or futures or forwards or options. While these are all instruments you can use to short, they can be highly dangerous if they move the wrong way. Implicit leverage from shorting can cause massive permanent capital losses.

Most short funds (with famous investors like Bill Ackman) are able to make the short trade work with producing lots of high quality research on the topic and spreading it. That takes the shape of activism that small and even medium scale funds cannot do – let alone retail investors. Another side effect of this type of activism is that it is very difficult to back track if you’re wrong after you have made many statements publicly one way or another.

Empirically I don’t know of any long short equity funds that have beaten the market for a 20 year period.