Investment Product Review

 

In this series we examine investment products and strategies, from the mundane to the highly complex, explaining how they work and why we do or do not use these particular products or strategies in our portfolios.

Alternatives: What are Directional Strategies?

 

Directional strategies are straightforward when compared to some complex alternative strategies.  These strategies are similar to those used traditional stock picking funds, with the additional twist of short selling1.  The most common directional strategies are long/short and short bias, each of which relies on the ability of the portfolio manager to select stocks that will outperform the market; or, in the case of short selling, underperform the market.

For example, equity long/short funds buy and sell short individual stocks, generally with a net long exposure for the portfolio as a whole.  The most common type of long/short funds is the 130/30 fund, which has 130% long exposure to stocks combined with 30% short exposure.  This combination is intended to replicate the “beta” or long exposure of the market being used, while outperforming a market index through superior stock selection.  Theoretically, if a manager was able to determine the best and worst performing stocks beforehand, the short exposure along with the additional long leverage that is allowed by using a short position would enhance outperformance more than would be possible through a simple long-only strategy, while maintaining a similar level of risk.

Short bias funds operate in a similar manner, but maintain a net short exposure to the market.  Unlike a 130/30 fund, a short bias fund will often adjust their net exposure based on current market conditions.  For example, in time of rising equity markets, a short bias fund would be likely to reduce the size of their short positions, whereas in bear markets they could increase short, even to the point of a 100% short exposure.  Over time, equities are expected to rise in value due to their risk premium, meaning that it will be difficult for short bias funds to generate positive returns during most market conditions, but their ability to perform strongly during falling markets has appeal as a hedge against equity risk.

While the idea of an enhanced return over an index through superior long and short stock selection sounds appealing, the reality is somewhat disappointing.  A preponderance of empirical research has shown that managers who can consistently beat an index through stock selection are extremely rare, and those who do occasionally outperform the index more than make up for that excess return through their fee structure.  Similarly, short bias funds are an interesting concept insofar as they might provide protection against a bear market, but once again these funds tend to detract value through excessive trading and high fees, and rarely make up for that through security selection.  Combine this with the fact that short bias funds are expected to (and generally do) lose money on average, it is hard to justify them as a portfolio hedge in place of a safer asset class like fixed income which tends to outperform when equity markets are down, but still provide value in good times.

References
1. Short selling is the process of borrowing a security in order to sell it, with the hopes of being able to repurchase the security at a lower price in the future.  For example, if you knew that the price of a stock was going to drop from $10 to $5, you could borrow that stock (generally from an institution), sell it on the market at $10, and then repurchase the stock when the price reached $5 and return it to the lender.  By making this trade, you would have made a profit of $5 per share sold short, less any interest that had to be paid in exchange for borrowing the stock.

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About Erik Lehr

Erik graduated from the University of Oregon with a Bachelor of Economics and Mathematics degree. His background includes master’s degree in economics and a Master of Science in Computational Finance and Risk Management from the University of Washington. Erik also holds the Chartered Alternative Investment Analyst (CAIA®) designation.

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