HF vs. LO: Vantage from a Junior Research Analyst - Part II: Duration Mismatch

HF vs. LO: Vantage from a Junior Research Analyst - Part II: Duration Mismatch

On last week’s article, a reader asked me: How does it work if my firm has both long only (“LO”) and long/short (“L/S”) strategies? Let me answer this great question:

  • There are too many permutations in this profession, but:
    • Generally when a firm has both LO and L/S products, they will employ more of a L/S approach to managing all of their products. However, if the LO product is managed by a PM who has never done L/S, it’s possible the LO product is truly buy-and-hold and not as focused on near-term risk management.
    • An aside that was not asked: A LO fund founded by an ex-hedge funder will likely have a L/S style process as well because that’s the style under which the founder was trained.

I hope this helps. This week I highlight the long/short duration mismatch inherent at a L/S fund.

Disclaimer: My discussion excludes multi-managers. And it’s impossible to generalize single-manager hedge funds that can have styles ranging from multi-managers all the way to a long only mutual fund.

At a L/S fund, there are two portfolios or “books” – a long book and a short book. I will vaguely use my experience with my prior shop as an example.

When I first joined, I noticed a few things about the existing portfolio:

  • Long book had 30 positions, but the short book had 50 positions
  • The top long positions were sized as big as 5% of total capital invested, but no short position was sized nearly as big
  • As months go by, the top long positions were the same but stocks in the short book kept changing

That’s the dynamic at a L/S fund:

  • Higher absolute number of short positions: in this case, 50 shorts vs. 30 longs
  • Short book turning over more quickly
  • Smaller position sizing: No 5% single short position

Two of dynamics above are interconnected: smaller position sizing is due to shorting being riskier than long, resulting in higher absolute number of short positions. And because of smaller position sizing, a fund needs to find as many loser stocks as possible on the short-side to generate alpha.

Why is shorting riskier? If you SOLD SHORT a stock at $50, that stock can go to $100, $500 or $1,000 – infinite loss potential if you aren’t careful! If you BOUGHT a stock at $50 and the stock drops to $0, you lose 100% of your capital – not great but at least risk is capped to your capital invested.

A very simple math analogy: Imagine a L/S portfolio of 1 stock on the long side (that’s concentrated AF!) and 5 stocks on the short side: You need to find only one $500 stock that can go up 20% for a $100 profit, but you will need to find 5 $100 stock that will go down 20% each for a $100 profit. (each stock will drop to $80, so $20 profit for each stock and $100 profit for 5 stocks).

For you as a research analyst, the implication is you will be tasked to research more short ideas in a year than long ideas at a L/S fund. It’s just something to be aware of: If you don’t really like to short stocks, you cannot really choose to only work on long ideas at a L/S shop. That said, you will spend more time digging deeper on a long position because of larger position sizing and longer time horizon.

That’s it for this week. If you have comment or feedback, please email me. I will talk to you next week.

If you are interested in learning more about professional equity investing (the "buy-side"), I have two other great articles for you:

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