Long / Short Is Better for Long-Term Investors Than Long Only

by: Veryan Allen

France is out of the world cup and it's Warren Buffett's fault? Berkshire Hathaway (NYSE:BRK.A) short sold and profited from its demise. Negative bets "cause" failure according to those who blame short sellers. Did the team fail due to fundamental problems or short sales? Have sovereign debt spreads widened due to amateurs belatedly realizing there are no risk free bonds or professionals using credit derivatives? The fact is that long only markets where short selling and derivatives are not allowed have worse drawdowns and volatility. And anyone not shorting is not hedging.

Some say short selling is a drag on returns, derivatives should be banned while security analysis and active manager selection are a waste of time. If there is no such thing as investment skill, there is no such thing as sporting skill? Anyone competent knows future talent is detectable in any field. It just takes hard work, due diligence and experience to find the top performers in advance. Skill must be unconstrained which is why mandating good managers to be long only gets similar results to blindfolding soccer players. For those who prefer human decisions to quant strategies, check out world cup referees' "accuracy".

A portfolio without shorts and derivatives is like a soccer team without defenders and goalkeepers. A winning fund requires strong management, teamwork and tactical adjustments to nimbly react to changing opportunities. The unhedged, unskilled crowd has underperformed cash since France won back in 1998; so far my best ever year but commonly regarded as "bad" for hedge funds due to the blow up of one. Hedge funds have demolished long only managers since England won in 1966; the year long/short was first widely publicized and shown conclusively to be superior. How much longer must most investors wait to be allowed to properly diversify and overweight skill?

For long term investors, long/short is safer and better aligned with economic reality than long only. Those seeking consistent performance invest in skilled managers, not asset managers. For funds that hold the largest stocks to reduce tracking "error", BP is yet another reminder that there are no blue chip, buy and hold "securities". BP stock crashed due to poor management or short sellers? If one hedge fund drops a few billion some urge avoiding all hedge funds, but when a stock loses $100 billion they don't say avoid all stocks. Why?

Avoid all bonds because of Greece? Every country is a great place for alpha. I recently met with a manager that blamed the "unprecedented" Greece situation for why they lost money! Proud of their terabytes of "historical" data to analyze, amazingly they were unaware Greece had many defaults in the past starting with Solon first trying to sort out the debt situation in 600BC and for over 100 of the past 200 years. Investors can learn a lot from the Greeks. On trial for daring to challenge conventional wisdom, Socrates' prophetic last words were "Please don't forget to pay the debt". Archimedes invented leverage and was prescient in saying "Give me enough leverage and I will move the world", considering how large borrowers have moved world markets recently. It always puzzled me how experts worried about leveraged hedge funds but regarded government bonds as risk free. The only risk free rate is zero.

Aristotle also had some investment advice. "The aim of the wise is not to secure pleasure but to avoid pain" - the wise short sell and hedge downside risk to avoid portfolio pain. "Hope is the dream of the waking man" - if you hope a losing position will turn into a profit or a traditional portfolio will fund retirement liabilities you are dreaming. "A great city is not to be confounded with a populous one" - invest with great funds, not necessarily the biggest asset gatherers. "The greatest virtue is those which are useful to other people" - absolute returns are always very useful to clients and they can't eat relative returns in down markets. Socrates said "I am not an Athenian or a Greek, but a citizen of the world" - invest in alpha opportunities anywhere, not the country you happen to be in. "The only good is knowledge and the only evil is ignorance" - ignorance in finance is plentiful but there has been good performance by the knowledgeable. Small losses are a cost of doing business; large losses come from ignorance.

While some still believe that shorts and derivatives fuel down markets, the fact is there is not enough use of them to diversify, hedge and make money. Stock market drawdowns need not negatively impact any investor's portfolio. With so many aspects of people's lives affected by the economy, their savings and retirement plans ought to be immune to the volatility of long biased equity and credit. The bull market tide went out recently revealing many naked, overly risky, poorly constructed portfolios. And for every Google (NASDAQ:GOOG), EBAY or Amazon (NASDAQ:AMZN), there are hundreds of failures. We get reminded of the rare stock that actually did rise over time but not the many more that disappeared or whose IPO was the date of the all time high.

Too much hope for the future relies on dubious assumptions that "stocks" rise over time. Long only credit is bad, long only equity is worse, long only commodities is crazy. Over time most equities fall as any thorough empirical examination of that disaster known as buy and hold confirms. Short selling permits absolute returns from the majority of stocks that go down over time. In my experience bear markets create more alpha opportunities. There are more losers than winners which makes it better to have more shorts than longs and benefit from the natural selection and creative destruction of the markets.

The weakest prey are the easiest. There are more longs than shorts out there. Lack of performance incentives means many long decisions aren't made for legitimate reasons. Some stocks are bought because they are in an index, not because they are good investments. Many bonds are held because of investment grade "ratings" regardless of yield. Analysts issue far more "buys" than "sells". Long only fund management has much larger AUM while weaker hedge funds tend to be [big] long/[tiny] short rather than long/short. Low returns and high correlation in May 2010 shows little has been learned from 2008 in terms of proper risk management, reducing market dependence or focusing on truly uncorrelated strategies.

The congenital long bias means shorting attracts a higher percentage of people who know what they are doing. In general the proportion of smart money in shorts is higher than the smart money in longs. Since alpha is generated by the skilled out of the unskilled, position against where the most unskilled money is. Despite what some still(!) say, there is no evidence that risky assets rise over time or compensate for risk. Alpha is zero sum - smart money makes alpha out of dumb money. Identifying dumb money usually means looking for weak longs and taking the other side. There is usually more dumb money on the long side than the short side.

Real alternative investments offer alternative returns. I have always evaluated hedge funds to replace market risk with manager risk. A "hedge fund" that is dependent on up markets for positive performance is of no use. Making money in bear markets is more valuable than absolute returns in bull markets. In good economic times. traditional assets perform, people have more spendable cash, greater access to credit and rising real estate values. Individuals and plan sponsors have more earnings to contribute to DB and DC pensions. Foundations and endowments receive more from benefactors. But in negative periods for asset classes, the need increases for absolute returns. In May 2010 we saw a mini repeat of 2008 where thousands of hedge funds made money but the "average" manager did not. Beta pollutes many alleged alpha engines. Alternative beta is as unsuitable for risk averse investors as traditional beta. Absolute alpha is what to look for.

Most of the greatest trades ever have been shorts. Whether it was John Paulson shorting subprime CDOs in 2007, George Soros the British Pound in 1992, Jesse Livermore USA stocks in 1929 or Munehisa Honma's rice short in 1789. There have been many attempts to ban short sales since Isaac Le Maire's famous short sale of VOC back in 1609. The only way to truly diversify or hedge a long is with a short. Why does conventional asset allocation range from 0% to 100% when investors could use -100% to +100%? Even better would be to acknowledge the failure of static asset allocation to deliver what investors actually need and put it in skilled uncorrelated long/short strategies.

Every investor needs short positions and to use derivatives. It's called hedging. Few managers have the capability to make money in bear markets. Sadly too many fail in due diligence to show they have the quality of risk management, strategy testing and expertise to deliver positive performance in negative periods. Despite the lessons of thousands of years, little has been learned about decorrelating a portfolio to underlying risk factors and immunizing against economic volatility. But the fact remains that long short is better for conservative investors than long only. Eliminate beta risk factors and focus on alpha from long/short market timing and security selection.