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Dedicated short bias strategy

January 13, 2023 by Youssef LOURAOUI

In this article, Youssef LOURAOUI (Bayes Business School, MSc. Energy, Trade & Finance, 2021-2022) presents the dedicated short bias strategy. The strategy holds a net short position, which implies more shorts (selling) than long (buying) positions. The objective of the dedicated bias strategy is to profit from shorting overvalued equities.

This article is structured as follow: we introduce the dedicated short bias strategy. Then, we present a practical case study to grasp the overall methodology of this strategy. We also present a performance analysis of this strategy and compare it a benchmark representing all hedge fund strategies (Credit Suisse Hedge Fund index) and a benchmark for the global equity market (MSCI All World Index).

Introduction

According to Credit Suisse (a financial institution publishing hedge fund indexes), a dedicated short bias strategy can be defined as follows: “Dedicated Short Bias funds take more short positions than long positions and earn returns by maintaining net short exposure in long and short equities. Detailed individual company research typically forms the core alpha generation driver of dedicated short bias managers, and a focus on companies with weak cash flow generation is common. To affect the short sale, the manager borrows the stock from a counter-party and sells it in the market. Short positions are sometimes implemented by selling forward. Risk management consists of offsetting long positions and stop-loss strategies”.

This strategy makes money by short selling overvalued equities. The strategy can potentially generate returns in falling markets but would underperform in rising equity market. The interesting characteristic of this strategy is that it can potentially offer to investors the added diversification by being non correlated with equity market returns.

Example of the dedicated short bias strategy

Jim Chanos (Kynikos Associates) short selling trade: Enron

In 2000, Enron dominated the raw material and energy industries. Kenneth Lay and Jeffrey Skilling were the two leaders of the group that disguised the company’s financial accounts for years. Enron’s directors, for instance, hid interminable debts in subsidiaries in order to create the appearance of a healthy parent company whose obligations were extremely limited because they were buried in the subsidiary accounts. Enron filed for bankruptcy on December 2, 2001, sparking a big scandal, pulling down the pension funds intended for the retirement of its employees, who were all laid off simultaneously. Arthur Andersen, Enron’s auditor, failed to detect the scandal, and the scandal ultimately led to the dissolution of one of the five largest accounting and audit firms in the world (restructuring the sector from the Big 5 to the Big 4). Figure 1 represents the share price of Enron across time.

Figure 1. Performance Enron across time.
img_SimTrade_Enron_performance
Source: Computation by the author

Fortune magazine awarded Enron Corporation “America’s Most Innovative Company” annually from 1996 to 2000. Enron Corporation was a supposedly extremely profitable energy and commodities company. At the beginning of 2001, Enron had around 20,000 employees and a market valuation of $60 billion, approximately 70 times its earnings.

Short seller James Chanos gained notoriety for identifying Enron’s problems early on. This trade was dubbed “the market call of the decade, if not the past fifty years” (Pederssen, 2015).

Risk of the dedicated short bias strategy

The most significant risk that can make this strategy loose money is a short squeeze. A short seller can borrow shares through a margin account if he/she believes a stock is overvalued and its price is expected to decline. The short seller will then sell the stock and deposit the money into his/her margin account as collateral. The seller will eventually have to repurchase the shares. If the price of the stock has decreased, the short seller gains money owing to the difference between the price of the stock sold on margin and the price of the stock paid later at the reduced price. Nonetheless, if the price rises, the buyback price may rise the initial sale price, and the short seller will be forced to sell the security quickly to avoid incurring even higher losses.

We illustrate below the risk of a dedicated short bias strategy with Gamestop.

Gamestop short squeeze

GameStop is best known as a video game retailer, with over 3,000 stores still in operation in the United States. However, as technology in the video game business advances, physical shops faced substantial problems. Microsoft and Sony have both adopted digital game downloads directly from their own web shops for their Xbox and Playstation systems. While GameStop continues to offer video games, the company has made steps to diversify into new markets. Toys and collectibles, gadgets, apparel, and even new and refurbished mobile phones are included.

However, given the increased short pressure by different hedge funds believing that the era of physical copies was dead, they started positioning in Gamestop stock and traded short in order to profit from the decrease in value. In this scenario, roughly 140% of GameStop’s shares were sold short in January 2021. In this case, investors have two choices: keep the short position or cover it (to buy back the borrowed securities in order to close out the open short position at a profit or loss). When the stock price rises, covering a short position means purchasing the shares at a loss since the stock price is now higher than what was sold. And when 140% of a stock’s float is sold short, a large number of positions are (have to be) closed. As a result, short sellers were constantly buying shares to cover their bets. When there is that much purchasing pressure, the stock mechanically continued to rise. From the levels reached in early 2020 to the levels reached in mid-2021, the stock price climbed by a factor of a nearly a hundred times (Figure 2).

Figure 2. Performance of Gamestop stock price.
Gamestop performance
Source: (Data: Tradingview)

In the Gamestop story, the short sellers lost huge amount of money. Especially, the hedge fund Melvin Capital lost billions of dollars after being on the wrong side of the GameStop short squeeze.

Why should I be interested in this post?

Understanding the profits and risks of such a strategy might assist investors in incorporating this hedge fund strategy into their portfolio allocation.

Useful resources

Academic research

Pedersen, L. H., 2015. Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined. Princeton University Press.

Business Analysis

Credit Suisse Hedge fund strategy

Credit Suisse Hedge fund performance

Wikipedia Gamestop short squeeze

TradingView, 2023 Gamestop stock price historical chart

About the author

The article was written in January 2023 by Youssef LOURAOUI (Bayes Business School, MSc. Energy, Trade & Finance, 2021-2022).

Long-short equity strategy

December 17, 2022 by Youssef LOURAOUI

In this article, Youssef LOURAOUI (Bayes Business School, MSc. Energy, Trade & Finance, 2021-2022) presents the long-short equity strategy, one of pioneer strategies in the hedge fund industry. The goal of the long-short equity investment strategy is to buy undervalued stocks and sell short overvalued ones.

This article is structured as follow: we introduce the long-short strategy principle. Then, we present a practical case study to grasp the overall methodology of this strategy. We conclude with a performance analysis of this strategy in comparison with a global benchmark (MSCI All World Index).

Introduction

According to Credit Suisse, a long-short strategy can be defined as follows: “Long-short equity funds invest on both long and short sides of equity markets, generally focusing on diversifying or hedging across particular sectors, regions, or market capitalizations. Managers have the flexibility to shift from value to growth; small to medium to large capitalization stocks; and net long to net short. Managers can also trade equity futures and options as well as equity related securities and debt or build portfolios that are more concentrated than traditional long-only equity funds.”

This strategy has the particularity of potentially generate returns in both rising and falling markets. However, stock selection is key concern, and the stock picking ability of the fund manager is what makes this strategy profitable (or not!). The trade-off of this approach is to reduce market risk but exchange it for specific risk. Another key characteristic of this type of strategy is that overall, funds relying on long-short are net long in their trading exposure (long bias).

Equity strategies

In the equity universe, we can separate long-short equity strategies into discretionary long-short equity, dedicated short bias, and quantitative.

Discretionary long-short

Discretionary long-short equity managers typically decide whether to buy or sell stocks based on a basic review of the value of each firm, which includes evaluating its growth prospects and comparing its profitability to its valuation. By visiting managers and firms, these fund managers also evaluate the management of the company. Additionally, they investigate the accounting figures to judge their accuracy and predict future cash flows. Equity long-short managers typically predict on particular companies, but they can also express opinions on entire industries.

Value investors, a subset of equity managers, concentrate on acquiring undervalued companies and holding these stocks for the long run. A good illustration of a value investor is Warren Buffett. Since companies only become inexpensive when other investors stop investing in them, putting this trading approach into practice frequently entails being a contrarian (buy assets after a price decrease). Because of this, cheap stocks are frequently out of favour or purchased while others are in a panic. Traders claim that deviating from the standard is more difficult than it seems.

Dedicated short bias

Like equity long-short managers, dedicated short bias is a trading technique that focuses on identifying companies to sell short. Making a prediction that the share price will decline is known as short selling. Similar to how purchasing stock entails profiting if the price increases, holding a short position entail profiting if the price decreases. Dedicated short-bias managers search for companies that are declining. Since dedicated short-bias managers are working against the prevailing uptrend in markets since stocks rise more frequently than they fall (this is known as the equity risk premium), they make up a very small proportion of hedge funds.

Most hedge funds in general, as well as almost all equity long-short hedge funds and dedicated short-bias hedge funds, engage in discretionary trading, which refers to the trader’s ability to decide whether to buy or sell based on his or her judgement and an evaluation of the market based on past performance, various types of information, intuition, and other factors.

Quantitative

The quantitative investment might be seen as an alternative to this traditional style of trading. Quants create systems that methodically carry out the stated definitions of their trading rules. They use complex processing of ideas that are difficult to analyse using non-quantitative methods to gain a slight advantage on each of the numerous tiny, diversified trades. To accomplish this, they combine a wealth of data with tools and insights from a variety of fields, including economics, finance, statistics, mathematics, computer science, and engineering, to identify relationships that market participants may not have immediately fully incorporated in the price. Quantitative traders use computer systems that use these relationships to generate trading signals, optimise portfolios considering trading expenses, and execute trades using automated systems that send hundreds of orders every few seconds. In other words, data is fed into computers that execute various programmes under the supervision of humans to conduct trading (Pedersen, 2015).

Example of a long-short equity strategy

The purpose of employing a long-short strategy is to profit in both bullish and bearish markets. To measure the profitability of this strategy, we implemented a long-short strategy from the beginning of January 2022 to June 2022. In this time range, we are long Exxon Mobile stock and short Tesla. The data are extracted from the Bloomberg terminal. The strategy of going long Exxon Mobile and short Tesla is purely educational. This strategy’s basic idea is to profit from rising oil prices (leading to a price increase for Exxon Mobile) and rising interest rates (leading to a price decrease for Tesla). Over the same period, the S&P 500 index has dropped 23%, while the Nasdaq Composite has lost more than 30%. The Nasdaq Composite is dominated by rapidly developing technology companies that are especially vulnerable to rising interest rates.

Overall, the market’s net exposure is zero because we are 100% long Exxon Mobile and 100% short Tesla stock. This strategy succeeded to earn significant returns in both the long and short legs of the trade over a six-month timeframe. It yielded a 99.5 percent return, with a 36.8 percent gain in the value of the Exxon Mobile shares and a 62.8 percent return on the short Tesla position. Figure 1 shows the overall performance of each equity across time.

Figure 1. Long-short equity strategy performance over time
Time-series regression
Source: computation by the author (Data: Bloomberg)

You can find below the Excel spreadsheet that complements the example above.

Performance of the long-short equity strategy

To capture the performance of the long-short equity strategy, we use the Credit Suisse hedge fund strategy index. To establish a comparison between the performance of the global equity market and the long-short hedge fund strategy, we examine the rebased performance of the Credit Suisse index with respect to the MSCI All-World Index. Over a period from 2002 to 2022, the long-short equity strategy index managed to generate an annualised return of 5.96% with an annualised volatility of 7.33%, leading to a Sharpe ratio of 0.18. Over the same period, the MSCI All World Index managed to generate an annualised return of 6.00% with an annualised volatility of 15.71%, leading to a Sharpe ratio of 0.11. The low correlation of the long-short equity strategy with the MSCI All World Index is equal to 0.09, which is closed to zero. Overall, the Credit Suisse hedge fund strategy index performed somewhat slightly worse than the MSCI All World Index, but presented a much lower volatility leading to a higher Sharpe ratio (0.18 vs 0.11).

Figure 2. Performance of the long-short equity strategy compared to the MSCI All-World Index across time.
Time-series regression
Source: computation by the author (Data: Bloomberg)

You can find below the Excel spreadsheet that complements the explanations about the Credit Suisse hedge fund strategy index.

Why should I be interested in this post?

Long-short funds seek to reduce negative risk while increasing market upside. They might, for example, invest in inexpensive stocks that the fund managers believe will rise in price while simultaneously shorting overvalued stocks to cut losses. Other strategies used by long-short funds to lessen market volatility include leverage and derivatives. Understanding the profits and risks of such a strategy might assist investors in incorporating this hedge fund strategy into their portfolio allocation.

Useful resources

Academic research

Pedersen, L. H., 2015. Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined. Princeton University Press.

Business Analysis

BlackRock Long-short strategy

BlackRock Investment Outlook

Credit Suisse Hedge fund strategy

Credit Suisse Hedge fund performance

Credit Suisse Long-short strategy

Credit Suisse Long-short performance benchmark

About the author

The article was written in December 2022 by Youssef LOURAOUI (Bayes Business School, MSc. Energy, Trade & Finance, 2021-2022).

Introduction to Hedge Funds

June 5, 2022 by Youssef LOURAOUI

In this article, Youssef LOURAOUI (Bayes Business School, MSc. Energy, Trade & Finance, 2021-2022) elaborates on the concept of Hedge Funds. Hedge funds are a type of asset class that differs from standard fixed-income and equities investments in terms of risk/return profile.

The structure of this article is as follows: First, we will define a hedge fund. Second, we provide a historical perspective on the first known hedge fund. Third, we will discuss hedge fund fees. Fourth, we discuss the conventional long-short strategy and provide an overview of the major hedge fund strategies. And finally, we end by discussing the economic importance of hedge funds.

Introduction

There is no straightforward definition of a hedge fund. Simply said, a hedge fund is an investment vehicle that aims to create performance by employing a variety of complex trading strategies. When the first hedge fund was introduced, the term “hedge” referred to lowering risk by investing in both long and short positions at the same time.

Hedge funds are exempted from the financial regulations that apply to other investment vehicles such as mutual funds. On the one hand, hedge funds have a lot of freedom to implement their investment strategy and face minimal disclosure rules. Hedge funds have the freedom to utilize leverage using derivatives products. On the other hand, hedge funds are restricted in the way they raise money from investors. Hedge fund investors must be “accredited investors,” which means they must have a particular amount of financial wealth and/or financial education to invest. Hedge funds have also been subject to a non-solicitation restriction, which means they are not allowed to advertise or aggressively seek individuals for investment.

According to the Security Exchange Commission (SEC, ), the governmental branch for regulated financial markets in the US, a hedge fund can be defined as follows:

“Hedge fund’ is a general, non-legal term used to describe private, unregistered investment pools that traditionally have been limited to sophisticated, wealthy investors. Hedge funds are not mutual funds and, as such, are not subject to the numerous regulations that apply to mutual funds for the protection of investors – including regulations requiring a certain degree of liquidity, regulations requiring that mutual fund shares be redeemable at any time, regulations protecting against conflicts of interest, regulations to assure fairness in the pricing of fund shares, disclosure regulations, regulations limiting the use of leverage, and more.” (SEC)

The first hedge fund: Jones

In 1949, Alfred Winslow Jones is said to have founded the first professional hedge fund and is regarded as the “father of the hedge fund industry”. He set up the fund as a limited partnership, with the hedge fund manager providing significant initial capital and a few significant investors. The fund’s principal strategy was to use a long/short method, the fund being long on undervalued securities and short on overvalued securities. Jones based his investment approach on stock picking (he believed he lacked market timing skills). Hedge funds’ main idea is that they can use leverage to boost returns in both directions.

From 1955 to 1965, Jones is reported to have achieved a 670% return on his hedge fund by taking both long and short positions. Before Jones, short selling had been popular for a long time, but he realized that by balancing long and short positions, he could be relatively immune to overall market changes while benefiting from the relative outperformance of his long positions against his short positions. The performance of Jones’s fund is shown in Figure 1 about the Dow Jones Industrials index used as a benchmark and Fidelity’s highest performing mutual fund. Over the 1960-65 period, the fund managed to multiply its return by a factor of four, which is higher than the best performing mutual fund (Fidelity Trend Fund) and the Dow-Jones industrials.

Figure 1. Alfred Winslow Jones’s hedge fund performance between 1960-65.
img_SimTrade_jones_performance
Source: “The Jones Nobody Keeps Up With” (Fortune, 1966).

Development of hedge funds

Interest in hedge funds grew after Fortune magazine published Jones’s results in 1966, and the Securities and Exchange Commission (SEC) listed 140 hedge funds in 1968. As institutional investors began to embrace hedge funds in the 1990s, the hedge fund industry saw a huge spike in interest. Hedge funds with billions of dollars under management were typical in the 2000s, with total hedge fund assets reaching a peak of nearly $2 trillion before the global financial crisis of 2008, dropping during the crisis, and recently reached a new peak.

Hedge funds’ aggregate positions are much larger than their assets under management due to their leverage, and their trading volume is a much larger part of the aggregate trading volume than their relative position sizes due to their high turnover, so hedge fund trading now accounts for a significant portion of all trading. Given a limited demand for liquidity, there is a limited amount of profit to be made and a limited requirement for active investment in an optimally inefficient market, the quantity of capital committed to hedge funds cannot keep expanding.

Hedge funds fees

Among the most frequent fees in the hedge fund industry, we can name the following:

Management fee

Management fee represents the fees that the hedge funds collect to run their operations (salaries, infrastructure, etc.). The management fee is usually about 3%

Performance fee

The performance fee is a compensation when the hedge fund achieves a certain level of performance. This threshold, called the hurdle rate, represents the minimum performance that a hedge fund has to achieve to charge an incentive fee. This motivates the hedge fund manager to perform and to align its interest with its clients’ interests. Beyond the hurdle rate, the outperformance is shared between the hedge fund manager (20%) and the clients (80%).

The high water mark (HWM) provision is a mechanism where the hedge fund will only charge performance fees if it manages to deliver returns above the returns of the previous period. If the hedge fund is down 50%, the performance achieved to recover the losses (100% won’t be subject to performance fees). Only after recovering entirely from the drawdown, the hedge fund can be entitled to earn the performance fee.

A classic hedge fund strategy: the long-short strategy

The long-short strategy is the strategy implemented by the first hedge fund (Alfred Winslow Jones fund). According to Credit Suisse, long-short equity funds engage in both the long and short sides of the equity markets, to diversify or hedge across sectors, regions, and market capitalizations. Managers can switch from value to growth, from small to medium to large capitalization equities, and from net long to net short positions. Managers can also trade stock futures and options, as well as equity-related instruments and debt, and form more concentrated portfolios than classic long-only equity funds.

To illustrate a long-short strategy, we create a hedge fund portfolio based on two stocks from the US equity market. We pick one overvalued stock and one undervalued stock based on their price-to-earnings (P/E) ratio. We chose for this purpose Twitter (overvalued) and Pfizer (undervalued). We download a time series of three-month worth of data for two stocks (Twitter and Pfizer) and the S&P500 index.

Figure 2 represents the regression of the returns of the simulated hedge fund portfolio on the S&P500 index. We can appreciate a null slope (0.0936) of the regression indicating the low correlation of the hedge fund with the market represented by the S&P500 index. This strategy is market-neutral, meaning that the portfolio is not correlated directly with the market fluctuations. The performance of a zero-beta portfolio would be derived from the alpha, a key metric in the portfolio management industry.

Figure 2. Regression of the hedge fund return on the S&P500 market index.
Hedge fund portfolio regression
Source: computation by the author (data: Bloomberg).

We compute the return and volatility of each security and the market index as a starting point. We also determine the correlation of the stocks to the market index. For the short position (Twitter), the sign of the correlation inverts of the sign. We compute an equally-weighted portfolio composed of two stocks: a long position on Pfizer and a short position on Twitter. This portfolio delivered a return of 0.27%, which is better than the broader stock index return over the same period (-0.22%).

Figure 3 depicts the return of the hedge fund portfolio relative to the market index return. From the analysis, the long-short strategy managed to outperform the S&P500 market index by 49 basis points. Even if the market is in a bearish setting, the strategy managed to deliver positive returns as the short position helps to be uncorrelated the return of the hedge fund from the market return.

Figure 3. Return of the hedge fund relative to the S&P500 market index.
Long short strategy performance
Source: computation by the author (data: Bloomberg).

You can download below the Excel file below which gives the details of the computation of the long-short strategy example.

Hedge fund role in economy

Hedge funds, for example, are frequently criticized in the media. Companies, for example, dislike seeing their shares shorted because it indicates a belief that the company’s share price will fall. Short sellers, including hedge funds, are sometimes blamed for a company’s problems, even though the stock price is usually falling due to the company’s poor financial condition, not because of any other source.

Hedge funds, in general, serve several important functions in the economy. First, they improve market efficiency by gathering information about businesses and incorporating it into prices through their trades. Because the capital market is the tool used to allocate resources in the economy, increased efficiency can improve real economic outcomes. Companies with good growth prospects see their share prices rise when markets are efficient, allowing them to raise capital and fund new projects. Companies that produce goods and services that are no longer required to see their share prices fall and the factories may be repurposed for more productive purposes, possibly leading to a merger. Furthermore, when share prices reflect more information and are more efficient, CEO decisions may improve, and they may be more prudent if active investors are monitoring them. Hedge funds also serve as a source of liquidity for other investors who need to buy or sell (e.g., to smooth out their consumption), hedge or buy insurance, or simply enjoy certain types of securities. Finally, hedge funds offer investors another source to diversify their returns.

Why should I be interested in this post?

As an investor, hedge funds may provide an opportunity to diversify its global portfolios. Including hedge funds in a portfolio can help investors obtain absolute returns that are uncorrelated with typical bond/equity returns.

For practitioners, learning how to incorporate hedge funds into a standard portfolio and understanding the risks associated with hedge fund investing can be beneficial.

Understanding if hedge funds are truly providing “excess returns” and deconstructing the sources of return can be beneficial to academics. Another challenge is determining whether there is any “performance persistence” in hedge fund returns.

Getting a job at a hedge fund might be a profitable career path for students. Understanding the market, the players, the strategies, and the industry’s current trends can help you gain a job as a hedge fund analyst or simply enhance your knowledge of another asset class.

Useful resources

Academic research

Pedersen, L. H., 2015. Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined. Princeton University Press.

Business Analysis

Wikipedia Alfred Winslow Jones

Fortune (2015) The Jones Nobody Keeps Up With (Fortune, 1966).

SEC Mutual Funds and Exchange-Traded Funds (ETFs) – A Guide for Investors.

SEC Selected Definitions of “Hedge Fund”

Credit Suisse Hedge fund strategy

Credit Suisse Hedge fund performance

Credit Suisse Long-short strategy

Credit Suisse Long-short performance benchmark

About the author

The article was written in June 2022 by Youssef LOURAOUI (Bayes Business School, MSc. Energy, Trade & Finance, 2021-2022).

Introduction

Example of the dedicated short bias strategy

Jim Chanos (Kynikos Associates) short selling trade: Enron

Risk of the dedicated short bias strategy

Gamestop short squeeze

Why should I be interested in this post?

Related posts on the SimTrade blog

Hedge funds

Financial techniques

Useful resources

Academic research

Business Analysis

About the author

Introduction

Equity strategies

Discretionary long-short

Dedicated short bias

Quantitative

Example of a long-short equity strategy

Performance of the long-short equity strategy

Why should I be interested in this post?

Related posts on the SimTrade blog

Useful resources

Academic research

Business Analysis

About the author

Introduction

The first hedge fund: Jones

Development of hedge funds

Hedge funds fees

Management fee

Performance fee

A classic hedge fund strategy: the long-short strategy

Hedge fund role in economy

Why should I be interested in this post?

Useful resources

Academic research

Business Analysis

Related posts on the SimTrade blog

About the author