ETF-Only Short Books Limit Double Alpha Strategy

by: Christopher Holt

When explaining what they do for a living, long/short hedge fund managers will often use the term “double alpha”. These managers attempt to generate alpha by outright stock picks in both their long and short books. “Double alpha” is also sometimes invoked when describing the removal of the long-only constraint to benefit from the Fundamental Law of Active Management.

Portable alpha - in its most basic form as a long position in an active manager and a short position in that manager’s benchmark - is not technically a “double alpha” strategy. By shorting the benchmark to isolate manager alpha, a portable alpha manager relinquishes any potential alpha from the short book. In other words, the short book is for hedging only.

But in an ominous development, reported by Marketwatch on Friday, long/short managers are loading up their short books with ETFs instead of individual securities. Apparently many managers now believe shorting individual stocks is too risky. Having once had a ringside seat to takeover-rumor inspired short squeezes on terrible stocks, I am sympathetic to this concern.

But where does that leave the much heralded “double alpha”? Well, I guess if the short book is full of a basket of ETFs whose weightings differ from those of the broad indices, then the short book can still be said to produce alpha. But if long/short managers drift toward a passive short position in their benchmark, they can no longer lay claim to the double alpha argument.

Instead, they essentially become portable alpha funds. This would be no big deal if such strategies were complicated and difficult to replicate. Unfortunately for long/short managers however, going long an active manager and short their benchmark is not rocket science. Such a world would put downward pressure on the fees paid by fiduciaries as they begin to view long/short managers as mere long-only managers with a (minor) twist. As a result, they may be reading from this song sheet when it comes to fees, not the usual “2 and 20″ melody.

Curiously, using ETFs in the place of individual securities in a short book actually works against 1X0/X0 strategies (and against their theoretical rationale, the Fundamental Law of Active Management). As the Marketwatch article cited above points out, shorting an ETF is a blunt instrument since it amounts to a short position in many names that the manager may not otherwise have wanted to short. In other words, the primary benefit of 1X0/X0 - increasing a manager’s ability to express a negative view on a stock - is erased in favor of short positions across the board (assuming for a moment that the manager shorts only her benchmark).

Sure, ETF-adopting long/short managers aren’t likely to create totally passive short books. But the transition from an all-stock short book to an all ETF short book necessarily reduces the very “degree of freedom” so vaunted by 1X0/X0 advocates. Good short ideas may be hard to find these days. But giving up on the ability to express a significant negative view on a specific security comes with its own risks.