I’m good at shorting, is it possible to start a short biased hedge fund? by Laurent Bernut
Answer by Laurent Bernut:
Excellent answer from Bill Chen, to which there is little to add. In my opinion, short-selling is widely misunderstood even by professional sophisticated investors. To add insult to injury, FED and ECB are the official sponsors of the longest bull market on record.
Did You know that deep in the quiet comfort of your house, there is something 150 times deadlier than a shark ? It is called a bed. The probability of dying after falling out of bed (literally) is 1/2*10^-6, while ex-sanguination from an exploratory shark bite is 1/150*10^-6. Sharks are misunderstood and fragile. So are short sellers.
Adding a short component to a long strategy reduces volatility of performance, increases leverage and reduces drawdowns in terms of magnitude, frequency an period of recovery. Now, this is neither how they are perceived nor marketed.
They are perceived as predatory, nefarious and risky in nature. I lost half of my pension in 2008 to supposedly buy and hold low risk mutual fund #de-friendBuy&Hold.
Short biased funds are relative players, just as your average mutual fund. Their benchmark is just the inverse of the index. When the market goes up by 10% and they clock +8%, effectively they have outperformed. The only problem is that investors lose -8% in absolute. No-one likes to structurally lose money, right ?
Wrong, 3/4 of mutual funds trail their benchmark year in year out. Investors make money in absolute but lose versus index funds. Worse even, mutual funds lose both in absolute and relative during bear markets. So, here is an interesting perception gap:
Short biased funds lose money during bull markets but make some during bear markets. Rationally speaking, they serve a more important purpose than mutual funds. Logically speaking, you do not need a mutual fund, but you do need a short biased fund in order to protect you from downturns.
The problem is that most of them will have died by the time we hit a bear market. The second problem is that short selling is still perceived as evil, when all they do is provide hedge in good times and absolute performance when no-one else does
BTW, small difference of opinion with Mr Chen, redemptions do not come during outperformance during bear phases. They come during early bull markets, when bearish sentiment as well as AUM peak. Short funds handle regime change quite poorly. The same happens with Long Only. Managers can underperform and still grow assets in bull markets because everyone makes money. Long Only underperforming in bear markets is bad…
Prometheus and capitalism
Monetary authorities around the world have mutually decided that bear markets are bad. So, they play god with the markets. They do whatever they can to prop them up. Their latest trick was a sucker punch to the very foundation of capitalism: negative interest rates. In what parallel universe does it make sense for a borrower to be paid to borrow money ?
This begets an interesting question: if they are blind enough to think they can tame the markets, will they be competent enough to solve the problems they have created ?
Anyhow, the point is the only trade in town is: when a tired bull market wants to go down, buy everything and wait for the monetary cavalry to show up with their QE heavy artillery.
This market manipulation is damaging for all market participants. It rewards complacency and bad behavior on the long only side (double down on losers) and wipes out short sellers. In March, i lost -15% in 3 weeks. This bull is tired but central bankers will not admit it until …
What’s the solution then ?
Once upon a time, mortgage bonds were boring. Then, someone figured out a way to package and MARKET them as low risk / high yield investment securities. Shortly thereafter, every other math wiz kid and smooth salesman became fluent in CDO linguo.
Same with short selling. As long as we are the “usual suspects” and default scapegoats for markets falling, speculation, corporate greed, obesity, erectile dysfunctions and all other evils on earth, small or large, then AUM will have wild swings. Picture a young promising executive pitching a short fund during an investment committee Monday morning 9 am
-“ things look a bit dicy here, i would like to start allocating to a short biased fund”, says the newbie
-“sure, buy a dividend fund or allocate more to government bonds funds”, replies the chairman
-”3% dividend is not going to cushion much when the market goes down -50%. Actually, government bonds are the reasons i am getting a bit nervous”, replies the young man
-”Now young man, how do you think our investors will perceive us if they know we are buying a short fund ? They will think we have no confidence in our economy. They will cease to see as patriotic, hard working, disciplined investors, prudent risk managers. They will think of us as short term traders, evil speculators. Rest assured they will redeem”, slams the chairman
-”You are right sir, but our clients will redeem anyway if we lose them money. Short sellers are just as patriotic, hard working and probably more disciplined than Long Only. Short sellers just happen to make money when no-one else around does. At least, if we make money for our clients, we have a chance to keep them. If we are one of the few who make money during downturns, maybe we could even grow assets. Look at Mr Paulson”, whispers the newbie as he shrinks and recoils away
-”You are a bright and talented young man. May i suggest a bit more optimism and team spirit for the rest of your career ?”, concludes the chairman with a paternalistic threat
The reason why John Paulson’s AUM exploded is: he made money when no-one else did. He stood out as a clear winner in a crowd of losers. Short selling is the most important and most valuable skillset. It just has bad press and needs to be repackaged.
Speaking of which, I am writing a book about short selling. 3/4 done already. It is about trading edge: statistical, mental and portfolio construction