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3 reasons why selling futures is a not a hedge to the Long book

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out_of_balance_-_Google_SearchIn 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”.

The view from the short-side: how we process emotions and the market signature of the 5 stages of grief

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Market participants are constantly asked to defend their conviction. The moment they have to justify their positions is the moment they lose impartiality. They become attached to whatever they have to defend. Being right is no longer about the process (taking calculated risks), but about the outcome (making money). A losing position is an attack on the ego. For this reason, market participants process emotions through a 5 stage cycle defined by Elizabeth Kubler Ross as the psychology of grief. Each phase has a distinctive market signature and even a specific language.

Summary:
  • Short sellers have a unique perspective on how market participants process emotions
  • The 5 phases described: market regime, market signature, language and profitable course of action

 I have been a professional short seller for almost a decade. For 8 years, my mandate was to under-perform the longest bear market in modern history: Japan equities. I have always searched for a way to identify the signature of human emotions across markets. Many respected market gurus have come up with charts plotted with emotions ranging from euphoria to despondency. Yet, they never really resonated with the short seller in me. Those were written by market participants with a natural Long bias. The short side offers a unique perspective on how investors process emotions. We, short sellers, never sell against buyers. We ride the tails of those who were once holders and now have to “accept” losses and “let go” of attachment.
There are three market regimes: bull, bear and sideways. Each regime can be subdivided into two categories: quiet or choppy. Bear markets usually start in sideways choppy markets: an epic battle between bears and bulls. They usually end in indifference: sideways quiet or bull quiet. Everyone has thrown the towel and no-one cares anymore.
The psychology of grief has five phases: denial, anger, bargaining, depression and acceptance. We will examine each phase looking at the market regime, the market signature, the language and a profitable course of action.
Phase 1: Denial
  • Market regime is usually sideways choppy. Stocks stop making new highs. They are trapped in a volatile range. Short interest is low. Bulls fight bears.
  • Market signature is the compression of estimates. Optimistic and pessimistic analysts have fairly close estimates. All available information has been “baked in” the estimates. The decisive factor is a sudden penetration through support level.
At this stage, analysts jump in and say two things:
  1. This is a “one-off”, “inventory adjustment”, “seasonal adjustment” etc
  2. This is a “Buy on Weakness opportunity”: Analysts are usually quite vocal as they appeal to market participants who were waiting for a pullback to enter a position
If a stop loss was not triggered, it is best to wait until the ensuing rebound is over to make a decision. If the new peak is below the previous high, then start trimming. When in doubt, reduce position size.
Phase 2: Anger
  • Market regime has morphed into a choppy bear. Stocks make lower highs and lower lows. Volatility remains elevated. Short interest start to tick up. Professional short sellers, such as myself, put a chip on the table just to see. Fast money, those who bought the dips and lost money, turn around and engage in some revenge short selling.
  • Market signature is characterized by institutional reducing their weight. Initial sellers are Long Onlys trimming their weights. Mutual funds may well keep their bets over the index, but they still trim their weights so as to reflect under-performance.
At this stage, analysts express their frustration:
  1. “…But the market does not understand …”: that is always an interesting argument, particularly after years of out-performance, institutional participation. Market probably knows something analysts refuse to accept yet
  2. “Short-sellers and speculators are taking the stocks down…”: ignorant analysts and market commentators blame us for stocks tanking, yet facts are stubborn: short interest is low. Secondly, in order to sell short, we need to locate borrow. Borrow availability represents a tiny fraction of the free float. Simply said, we just do not have the might to take anything down.
At this stage, it is prudent to aggressively reduce bet size for two reasons: 1) Volatility remains high and 2) performance does not justify a big position anyway. For market participants with a Long/Short mandate, this is a good time to anchor a small short bet. Position sizing is crucial as volatility remains elevated. Those anchors become invaluable when stocks move into the next phase as they embed substantial profits.
Phase 3: Bargaining
Me: “Doctor, if I eat my vegetables, stop drinking, smoking, eating poorly and exercise more, will I live longer ?”
Doctor: “I don’t know, but it will feel much longer anyway”
  • Market regime shifts from bear choppy to bear quiet. Bears have won the battle.
  • Market signature is a softening of a leading indicator that triggers a downgrade of estimates. Negative earnings momentum attracts short-sellers. Short interest start to rise.
At this stage analysts bargain with their conviction:
  1. “We take our estimates down, we revise our target price, we extend our investment horizon, but…”: Since analysts were ardent supporters, they believe they cannot change their mind at once
  2. “… We keep our Buy rating, because the long-term story is still intact”: the softening is not perceived as the symptom of a disease but a temporary setback
Analysts devote their existence to a few stocks. They know something is wrong but they cannot publicly admit that it is time to let go, but market participants can read through the lines and sell. Price action has already shown some weakness, but quantitative short sellers see negative earnings momentum as the sign to build positions. Short interest rises and so does the cost of borrow. This is when anchoring a small position in the previous phase becomes invaluable: borrow was secured at a cheap cost.
 
Phase 4: Depression
  • Market regime is bear quiet to bear volatile because of short squeezes
  • Market signature is 1) deterioration of newsflow , 2) radio-silence from the analyst community and 3) rapid increase in short interest
At this stage analysts:
  • crawl under their desks: they hardly contact companies or market participants
  • “this is a stock for long-term investors”: to which there is only one retort: “then it should be matched by long-term commissions”. If they frown, sell short…
Short interest rises quickly. The quality of borrow deteriorates (callable stocks, usury borrowing rate etc). It becomes costly and difficult to sell short. As a rule of thumb, do not sell short when short utilization (shares borrowed/shares available) rises above 51%. Volume is thin so any tiny event can trigger a short squeeze. Amateur short sellers are forced to cover, which trigger a cascade of short cover.
Phase 5: Acceptance
When the inexorability of reality sets in, there is a sort of euphoric relief.
  • Market regime is either quiet bull (small higher highs, higher lows) or sideways quiet
  • Market signature is terrible news-flow, massive downgrade from the analyst community, elevated short interest (crowded short). It is also muted price action: stocks do not react to a torrent of bad news anymore
At this stage, analysts are frustrated and no longer afraid to tarnish their standing with companies. They downgrade ratings, estimates and publish some vitriolic content such as:
  1. “Structural short”, “flawed business model…”, “…mismanaged”: it sometimes becomes personal, because analysts had a rough inner journey being champions of a lost cause
When all the negativity, particularly the words “structural words”, does not move share price anymore, it is a sign that the worse is over. There is one logical thing left to do: cover the short and go long.
Discussion
Markets are the ultimate mental sports. As much as we would like to think we are rational, the moment we are asked to defend our opinions is the moment we lose impartiality. The irony is that we intuitively know when something is not quite right. Still, we feel obligated to defend our stance. We refuse to admit reality, so we go through a painful process that eventually leads to acceptance. Pain is inevitable, suffering is optional. Making money in the markets is not about trying to be right, it is about accepting to be wrong and move on. Would You like to learn simple powerful techniques designed to reconcile the need for conviction and the reality of losses ?
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