3 reasons why selling futures is a not a hedge to the Long book
In the Long/Short equity space, managers find it difficult to find “good shorts”. So, they resort to selling futures in order to reduce the net exposure (Long – Short exposures). With low net exposure, volatility comes down, VAR is apparently low, so it is possible to leverage up again; problem solved, or not ? Selling futures solves only one of the five major hedges: gross, net, Beta, market capitalization, concentration. Selling futures is an implicit bullish bet on the market. It all works well, until it doesn’t. In this article, we will look at three reasons why selling futures is not an all-weather hedge to the short book. We will also look at other ways to hedge the short book.
On January 24th, 2006, the arrest of Horie-san, president of LiveDoor, sent the Japanese market into a tailspin. Despite our collective best efforts to reassure investors that we were properly hedged, our performance suffered. On the surface, it seemed like we had low net exposure, reasonable gross exposure (Long + Abs(Short) exposures or leverage). Yet, we were caught like deers in the headlights, watching our performance inexorably sink day after day. The source of our problems to one big position in the short book: March 06 futures.
Selling futures is not a hedge for three reasons
- Selling futures as a form hedge is an expensive form of laziness
- Short futures is an implicit bet on market cap
- Short futures is an implicit bullish bet on Beta
Selling futures as a form of hedge is an expensive form of laziness
Investors do not need to pay 2% & 20% for something they can do themselves. In fact, many investors are already natural hedgers. For example, insurance companies routinely trade futures and index options. Selling futures in lieu of single stocks unfortunately shows lack of skill in the Long/Short craft.
Some managers argue that net exposure management is an important tool in their arsenal. Managing net exposure is vital to deliver superior returns. When investors hear this, they understand “Beta jockey”. At 40%+ net Long, this is no longer a hedge, this is directionality. During the GFC, directional hedge funds did not bring the net to -30%, or at least -10% net Short. Net exposure continued continued to hover about +10/20%, sometimes neutral at best. Managers may have said they wanted to be positioned for the rebound, but in reality they were just scared. They did not know how to hedge and it was the wrong time to learn.
Hedging is a delicate craft that must be honed during bull markets. Those markets are more forgiving. As long as performance goes up, mistakes can be forgiven. When the going gets rough and patience of investors wears thin, hedging mistakes can be deadly.
There is one exception where selling futures as a hedge shows superior skill. When net exposure remains below +/-10% throughout the cycle, performance comes from the excess return over the index. This is as close as it will ever get to pure alpha in the equities world. This is a rare skill: managers understand they are not good at short-selling, so they concentrate on delivering excess returns, only partially juiced up by some residual market exposure. Managers who can deliver genuine excess returns deserve recognition and unsurprisingly see their AUM grow over time, survive and thrive through the thick or thin.
Long Stocks/Short future is an implicit bet on market cap and exchange
Managers like to invest in small/mid caps. This is where the fun and the gold nuggets are. Small-mid caps tend to have better upside potential than large caps during bull markets. Besides, stories are interesting. It is easier to have access to senior management. Uncover a few 3-4 baggers and a new stock picking star is born.
On the other hand, futures are a reflection of the underlying large caps in the index. For example, Topix Core 30 accounts for more than half of Tokyo first section market capitalisation. So, performance of the index is driven by its top caps.
Then, selling futures and buying small-mid caps is an implicit bet on market cap: Long small/mid caps, Short large caps. It goes even one step further. It is often a bet on the exchange: small/mid caps are often listed on different sections of the exchange. So, it can take the form of Long Nasdaq/Short S&P 500, Long JSDA / Short Nikkei, Long Kosdaq / Short Kospi etc.
As usual, it all works well until it doesn’t. Small/Mid caps do better than large caps in bull markets. In bear markets however, small/mid caps fall faster and harder than large caps. This is what happened to us in 2006. Our Long book fell -4-5% everyday. Liquidity evaporated. We could not get out of stocks without pushing them even further down. Meanwhile, our short book only fell by 2%, leaving a gap of -2-3% every day. Selling futures is an implicit bullish bet that works as long as the market stays bullish.
The psychological implications are even worse. As much as waiting for the first heart attack is not recommended to start living a healthy lifestyle, waiting for a bear market is a bad time to start learning the discipline of short selling. Selling short is a muscle that atrophies when not flexed. Managers grow complacent during bull markets. They believe “good shorts” will be plenty available when the market turns bearish.
Unfortunately, bear markets are harder to trade. Volatility increases, volume drops, bid/ask spreads widen, borrow becomes harder to source and squeezes can be vicious. Small caps may drop and look like great shorts, but in practice, they are hard to sell short. Obvious shorts quickly become crowded and once they do, they rarely fall as fast as the market.
On top of this, investors are risk-adverse and prone quick to redeem. So, trying to learn a difficult skill in a tough environment, without being allowed the luxury to make mistakes is hardly a good recipe for a lasting business.
Long Stocks/Short future is an implicit bet on Beta
The index has a Beta of 1. Since futures are a reflection of the index, they have a beta of 1. Small/mid caps outperform the index during bull markets. They therefore have a Beta above 1. So, Long small/mid caps/Short futures is therefore an implicit bet on Beta.
The difficulty comes with the first derivative of Beta, or speed. When the drop comes, it is sudden and violent. In our 2006 “soft patch”, one investor noted that we had a beta of 1.5 on the way up and 3 on the way down, after which he proceeded to redeem his investment. The only way to manage the short book via futures is to turn Beta neutral to negative. All things being equal on the Long side, that means large negative net exposure, something that traditionally net long managers are not comfortable doing.
A classic solution is to replace small/mid caps on the Long side with Low Beta stocks such as utilities, pharmaceuticals, food stocks. Net Beta can be negative, or below while net exposure can stay marginally positive. It works, but this is a reactive move implemented only after the reality of bear market has settled in. That usually comes after a drawdown.
How to edge properly then ?
Are VIX options a real hedge ?
Every time there is an earthquake, earthquake insurance sales go up. They then peter out over the next few years. Every time the market tanks, VIX goes up and investors rush to buy VIX options. VIX options become rapidly expensive. Besides, VIX is the only true mean reverting asset class. Trading VIX options is therefore an expensive form of hedge, hardly profitable in bear markets.
Absolute versus relative series
Analysts often complain that short ideas are hard to find in a bull market. This is true, but only if they look at absolute series. If one is to divide absolute prices by the closing price of the Index (relative series), then quite a different world starts to emerge. There is ample supply of underperformers out there, matched by an abundance of outperformers. This is however a paradigm shift. The objective is no longer to generate money in absolute terms. In fact, the true meaning of Long/Short is excess return over the index on the Long side and excess return over the inverse of the index on the short side.
All of a sudden, it becomes much easier to hedge the Long and Short side. Furthermore, competition is not as intense as in the absolute world. Shorts are not as crowded, because in absolute terms, they still look like they are going up, only slower the rest of the market. So, one would enter a short, knowing it would probably lose money in absolute terms. That is a challenging psychological hurdle. Years into it, It is still hard to intellectually reconcile positive performance, despite a full red inked absolute P&L column.
The main drawback of the relative series is the added complexity of calculation. Everything has to be divided by the index: charts, stop losses & target prices, risk management, even performance. The architectures of portfolio management systems radically differ. Imagine sending a limit order in absolute (try and send your favorite broker) a relative currency adjusted but managing stop losses in relative terms. It takes time to getting used to it, but the reward is well worth the effort. Short and Long candidates are abundant. Volatility is much lower, which makes it more commercially attractive to investors. Institutional investors prefer low volatility consistent returns over highly volatile performance. For example, the largest hedge funds in the equity space do not shoot for the moon, they do want to beat the market, they just aim to deliver high teens performance year after year.
Conclusion
Selling short is a muscle that atrophies each time futures are sold in lieu of stocks. As much as waiting for a heart attach is not the best time to start exercising, waiting for the bear market is the wrong time to learn the discipline of selling short. Investors are not dupe: they see through directionality and large futures positions on the short side. They have been there before and they did not like it then.
Shorts are plenty available all the time. They are just not going down in absolute terms but relative to the index. It implies a complete rethinking of both sides. It takes practice to learn but over the years investors have rewarded managers who deliver low volatility consistent returns from stocks on both sides of the book. As John F. Kennedy said, The time to repair the roof is when the sun is shining”.
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This was thought provoking. Chewing over this and rethinking what I do. Thanks Laurent
Kia Ora mate,
Thanks for the comment, much appreciated. I will see You soon in Tokyo.
Cheers,
Laurent
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