If you’re a typical long-short hedge fund manager, chances are you use exchange-traded funds (ETFs) as follows. You focus on only the most liquid and well-know ETFs – the S&P 500 ETF SPY, the Nasdaq 100 ETF QQQ, and semiconductor HOLDRs SMH. You use them mainly on the short side, to reach your desired net exposure. And you choose between them depending on how much beta you want: SMH is more volatile than QQQ, which in turn is more volatile than SPY.
Perhaps also you try to match your longs on a sector basis: if you are long semiconductor stocks, you short SMH; other technology stocks, you short QQQ; and otherwise you just short SPY.
But there’s a serious problem with that approach:
Many long-short equity hedge funds suffer from market cap bias. Fund managers believe they can generate alpha more easily from small cap stocks, so they hold them as long positions. But since shorting small caps is hard due to liquidity and borrowing constraints, there’s often a mismatch between a fund’s market cap exposure in its longs and shorts. Using ETFs dominated by large cap stocks as shorts to hedge long positions in single stocks perpetuates this problem, and leads to an implicit bet in favor of small caps and against large caps.
Last year that bet would have worked fine, as small cap stocks outperformed large caps. This year, however, a net bet in favor of small caps looks much riskier. First, on most valuation metrics small caps have become relatively pricey in the last 12 months. The Russell 2000 small cap index trades at a forward P/E of 28, versus the S&P 500’s forward P/E of 17, for example. Second, small caps tend to fare worse in a rising interest rate environment, because more of their value is in future earnings (which are discounted back using current interest rates) and smaller companies tend to be more dependent on debt financing.
Here’s a graphic example, from publicly available data, of how one fund manager was bitten by an unintentional market cap bet in his portfolio. John Hussman runs one of the few mutual funds that is actually a hedge fund - the Hussman Strategic Growth Fund (MUTF:HSGFX), a mutual fund that uses options and futures as a hedge. Hussman's options positions vary depending on his view of the current market climate, and his long-term results have been great: the Hussman Strategic Growth Fund has one of the highest Sharpe ratios of any mutual fund. However, Hussman made a basic error. His portfolio of long stocks included a variety of market caps, while he used S&P 100 futures to hedge.
In August of this year, Hussman's hedge turned out not to be such a good hedge. Here’s how he described the problem in his August 9th letter to investors:
How much harder?
There are three basic factors that have contributed to the recent 6.5% pullback in the Strategic Growth Fund… Second, the broad market, including much of the portfolio held by Strategic Growth, has had a harder time since April 5th than very large cap stocks have experienced.
Look at the numbers. The Hussman Fund losses are almost exactly equal to the difference in performance between the Russell 2000 and the S&P 100. Not paying attention to market cap bias in the portfolio killed him.
From April 5th through Friday of last week, the small-cap Russell 2000 has declined by 14.3%, the S&P 600 MidCap Index has declined by 10.6%… Meanwhile, the large-cap S&P 100 index has declined by 7.3%, and the Hussman Strategic Growth Fund has declined by 6.5%.
By August 30th, he’d corrected the situation by including the Russell 2000 in his hedge:
…the diversified stock portfolio held in the Strategic Growth Fund remains fully hedged with an offsetting short sale in the OEX and Russell 2000.
My guess is that many long-short hedge fund managers are in the position Hussman was in before August 30th. Personally, I don't think the relative correction in small caps is over. If the dollar declines, for example, small caps could be hit harder than large caps since they have a lower percentage of foreign sales. (A falling dollar would boost foreign sales in dollar terms.)
Better use of ETFs could go a long way to reducing long-short managers' net exposure to small caps. Given how easy it is to find the appropriate ETFs, there will be no excuse if fund managers get this wrong.
The ETF Resource Page is the most comprehensive list of annotated ETF links on the Web. It includes links to all the major ETF families.
John Hussman's weekly letters are excellent. They are one of the free resources for hedge fund managers listed in The Market Resource Page.