I recently
came across an interesting investing strategy known as Long-Short
Strategy (LSS). Being mostly a Long Only (LO) investor, Long Short
strategy made an interesting reading for me and expanded investment
alternatives that I can practice in stock market. I guess many of
you also might like to know about this relatively unpopular investing
approach. So here is the LSS as I know and perceive it.
How
Long-Short Strategy (LSS) differs from conventional Long Only Strategy
(LOS)?
LSS is mostly applicable to equity/stock markets. Here
you attempt to eliminate or minimize market
risk in contrast to the non-market
(aka company specific) risk that a diversification strategy
typically attempts to minimize.
Most
of the investors in the market are Long Only investors. In Long Only,
you try to select best stocks and buy them. If the stock
goes up after you purchase it, it is your gain and if it goes down,
it is a potential loss to you. This is what most of us do all the
times in the stock market. Long Short goes one step further. In a
typical LSS, besides buying stocks, you would simultaneously short
sell some weak stocks (of course of a different company). Here the
goal is to match long positions with short positions in such a way
that it eliminates some risk. One would ask what is the benefit of
going long as well short in the market at the same time? Isn't short
selling too risky?
Investment
risks
For an investor with surplus money, buying stocks and holding them
over some period makes sense as stock prices tend to go up over longer
time horizons. However if making money is the primary objective by
exploiting security mis-pricing as many traders and market professionals
do, one has to look at investment risks more closely.
Equity
investment risk can be divided into two components:
A. Market risk: The movement
in the overall market that influences stock prices.
B. Security Selection risk: Company
specific factors that affect a stock's price.
Market
Risk: Everybody knows about market risk. Let us say I buy
BRCM because I think it is a great company. However a fluctuation
in BRCM on a given day is caused by either the tone of the general
market or some developments specific to BRCM. I tend to believe
that on most, maybe as many as 80% of the days, the fluctuations
in BRCM stock would follow the market. If the market does well,
so does BRCM. If the market is down, chances are BRCM would be down
too. However good BRCM maybe as a company, it is subject to overall
market movements and investor sentiments. This is the market risk.
It is not a bad risk. If you are a long-term investor, this is the
risk that rewards you. If you saw your portfolio value skyrocket
in early 90s and also saw it get into gutters in 2000-2002, the
main factor behind it was this risk- market risk.
Security
Specific Risk: Once we eliminate market risk from a given
stock's total risk (price fluctuations), what we are left with is
security specific risk. It is not easy but not impossible too, to
segregate total risk into market risk and security specific risks.
(Read the Modern Portfolio Theory and Performance Attribution methods
if you are interested.) Luckily we don't need to know exact proportion
of these two risks for various stocks to practice LSS. Just understanding
them and acknowledging their existence and impact on our investments
is enough.
During
an investment decision process, we spend time figuring out what
we should buy (security selection based on security specific reasons).
However unless we are a very long-term investor, we are also taking
a position on the direction of the overall market for our time horizon.
Over a long term, markets tend to go up; but in between we may have
years like 2000 and 2001 that are hard to live by. When we are long
only for some specific time period, knowingly or unknowingly, we
assume, or at least hope, that the market will go up. We may buy
a great stock, but if the market keeps sinking, we would have hard
time realizing our goal of making money on it. So security specific
research/risk is of limited use when it gets mixed with market risk.
How
to minimize risk?
Most
of the investors know how to minimize investment risks: diversification.
We are told that the more we diversify, the more we are able to eliminate
the risk. This is only half –truth. As we know, investment risk
has two components. With diversification, we reduce security specific
risks. If BRCM has bad news, MO may have good news. If CSCO is going
down, TYC may be going up. So when we look at everything in aggregate
fashion, the company specific risks are somewhat eliminated in our
portfolio. However, the benefit of diversification ends there. Diversification
does not remove market risk from your portfolio nor does it help you
exploit company specific research. If the Dow were down by 200 points,
sure your diversified portfolio would have a bad day too. If the S&P
500 return were negative 20% last year, your diversified portfolio
would also be in more or less loss. If you have CSCO in your portfolio
and say it goes up by 10%, it does little good when we look at the
portfolio level. A 5% CSCO position would influence a portfolio's
return by 0.5% assuming all other things equal.
So
in Long Only strategy, we are rewarded for market risk we take.
Investment
strategies based on the risk we want to take:
Any investment
decision-making process should ask this
question first. What risk we want to take?
- If
you want to take market risk but eliminate company specific
risk, you should keep doing what we, most investors, have
been doing for all these years. Buy stocks and build a diversified
investment portfolio. This is nothing but Long Only strategy.
- If
you want to take market risk as well as company specific risk,
you should do a thorough research and buy/sell stocks based on their
prospects as well as your expectations about the overall market
return. You should maintain a portfolio with concentrated positions
in few stocks. Diversification should be avoided here.
- If
you want to take no risk- neither market risk nor
company specific risk, come on. Don't spend time reading this article
or looking around on Internet. You would be better off giving your
money to banks, US Government or by keeping surplus in insured
money market accounts, CDs or Bonds.
- If
you want to take company specific risks only but no market
risk, enter to the wonderful world of Long Short investing.
Long
Short Investing:
LSS (Long
Short Strategy) is often referred to as market neutral investing as
it attempts to eliminate market risk from the portfolio. LSS is not
suitable for all investors though. It maybe suitable for those investors
- who
think they have superior security selection skills
- who
think their market timing skills are poor or they want to eliminate
market risks.
- who
want to benefit from upside potential of promising stocks as well
as benefit from downside risk of weak stocks.
- who
have more risk appetite than most investors. (This is disputable.
A Long Short may not be riskier than Long Only!)
How
to implement LSS?
In loose
sense, you may want to find one bad stock for every good stock you
want to buy. If I want to buy BRCM, I would also need to find a stock,
let us call it X, to short which is expected to do bad. Holding both
stocks together, one long and one short, would help remove most of
the market risk from the combined position. If market goes down, BRCM
would go down so you would lose on your long position. However stock
X is also likely to go down with market. As you are short on X, you
have a profit there! Thus market impact is minimized. If our security
selection skills are superior, BRCM would do better in comparison
with overall market and X would do worse. Let us assume that the markets
are down by 20% during our investment horizon. As BRCM did better
than market, it maybe down by 10%. As stock X did worse with respect
to the market, it may be down by 30%.
So our
profit= Return on long position - return on short position.
Profit
= (-10%) - (-30%) = 20%
Another
scenario. If markets did well with S&P 500 return of +15% with
return on BRCM of 30% and return on X of 10%.
Profit in this situation is again = 30% - (10%)= 20%.
There
is one more advantage. In Long Short, you pay for the long positions
but your account gets credited with short sell proceeds (depending
on margin laws). This results in excess portfolio liquidity in comparison
with a Long Only portfolio. So proper cash management can add some
extra return to a Long Short portfolio.
This
is how a typical Long Short Strategy works. It eliminates market risk
and rewards you based on your security selection risk. However if
our security selection turns out to be bad, Long Short becomes a double-edged
sword and we may end up losing more in this strategy. The stock we
are long may do worse than the stock we are short and we may get hurt
on both positions.
So a
key element for a success in Long Short strategy is our security selection
skills.
Risk
Control in Long Short Strategy:
1.
Pair diversification: You make a pair of trades (long and short positions) instead
of looking at aggregate long and short positions at the portfolio
level. (This is somewhat contrary to Long Only. In Long Only you look
at risk at the portfolio level and not at an individual stock level.
However in LSS, you look at risk of a pair of trades). Say you like
Pfizer in Drugs sector but you don't like Merck due to their prospects
over next two years. Both being in same industry/sector, they both
are likely to be equally affected by market as well as industry specific
reasons. So they make a perfect long-short pair.
2.
Beta: Beta is a measure of a
stock's volatility with respect to market. So we may want to make
a pair of long and short stocks that have equal beta. Equal beta shows
identical sensitivity to market risk.
3.
Sector positions: Let us say at a particular point in economical cycle, you
like retail stocks but don't like housing stocks. So you may want
to take long position in a retail stock(s) but short position in a
housing stock(s). Here we are trying to avoid market risk and focus
on industry specific reasons (along with security specific factors).
4.
Equitizing a Long Short Strategy: Sometimes it pays to take market
risk if our view is bullish or a bearish on the market. With Long
Short, we can buy/sell index Futures to take a position on the market
or we can have a long short ratio that is less or greater than
100%. For say 1 million dollars in long positions, we may have 500,000
(if we are bullish) in shorts or 1.5 m (if we are bearish) worth of
short positions.
5.
Diversification: It helps to have more long-short pairs
in the portfolio than only a few pairs. This is the same old diversification
argument. When you have more pairs, your portfolio return becomes
more stable.
Caution:
§
Long Short attempts to eliminate market risk but magnifies
security specific risks. Hence it is more suitable for investors who
have superior security selection skills.
§
Short-term fluctuations in stock prices are less predictable
than long term ones. So you need to give this strategy a reasonable
time instead of cutting it short due to unfavorable short-term developments.
§
It is beneficial to practice diversification and have
more long-short pairs in the portfolio. This tends to eliminate overall
risk of the portfolio.
§
When practicing Long Short, you have to keep some short
selling limitations in mind. You can’t sell short on a down
tick. For a short sell, you or your broker has to borrow shares for
you and there is a risk that you may have to cover your short prematurely
if the shares are recalled. Though it rarely happens, a bear trap
in a stock you are short may cause the stock price to go up much quickly
than would be normally justified.
§
You need to have a well thought exit strategy. Would
you close both positions simultaneously? What if one of the stocks
in your pair has some unexpected developments? What if one of the
stocks in the pair has reached its target but not the other?
Email
me if you want to add something or have a question or comment
on above write up. Thank you
