CHAPTER 12
Equity Hedge
EQUITY HEDGE, also known as long/short equity, combines core long holdings of equities with short sales of stock, stock indexes, or derivatives related to equity markets. Net exposure of equity hedge portfolios may range anywhere from net long to net short, depending on market conditions. Managers generally increase net long exposure in bull markets and decrease net long exposure (or may even be net short) in bear markets. Generally, the short exposure is intended to generate an ongoing positive return in addition to acting as a hedge against a general stock market decline. Stock index put options or exchange-traded funds are also often used as a hedge against market risk.
In a rising market, equity hedge managers expect their long holdings to appreciate more than the market and their short holdings to appreciate less than the market. Similarly, in a declining market, they expect their short holdings to fall more rapidly than the market falls and their long holdings to fall less rapidly than the market. Profits are made when long positions appreciate and stocks sold short depreciate. Conversely, losses are incurred when long positions depreciate and/or the value of stocks sold short appreciates. Equity hedge’s source of return is similar to that of traditional stock-picking trading strategies on the upside, but it uses SHORT SELLING and HEDGING to attempt to outperform the market on the downside. Some equity hedge managers are value oriented, others are growth oriented, while a third category is opportunistic depending on market conditions.
Of all the hedge fund strategies, equity hedge strategies have the purest lineage. They are a direct descendent of A. W. Jones’s original “hedge” fund. However, as was the case in the initial hedge fund rush of the late 1960s, during the bull market of the 1990s many practitioners forwent the short exposure that was characteristic of the original funds. Thus, the present incarnations of the strategy can be roughly divided into two groups: equity hedge and equity nonhedge. The equity hedge strategists who are true to the original formulation retain the old structure that combined a core leveraged long stock position with short exposure that protects against downside risk. Equity nonhedge strategists use a strategy similar to traditional long-only strategies but with the freedom to use varying amounts of LEVERAGE. Although most of them reserve the right to sell short, short sales are not an ongoing component of their investment portfolios, and many have not carried short positions at all. This chapter discusses equity nonhedge as a variation of the equity hedge strategy. At heart, these are both concentrated stock-picking strategies, one that hedges market risk by augmenting core long positions with short positions, and the other that forgoes that short exposure. The freedom to use leverage, take short positions, and hedge long positions is a strategic advantage that differentiates equity hedge strategists from traditional long-only equity investors.
CORE STRATEGY
Equity hedge strategists combine core long holdings with short sales of stock or stock index options. Investors sell stock short if they expect the price of the stock to decline. To sell a stock short, an investor borrows that stock and immediately sells it on the market with the intention of buying it back later at a lower price and returning it to the lender. If the price of the stock declines, then the investor makes profits on the difference between the selling price and the cost of the replacement stock. The cash proceeds from the sale are held in a money market account, earning interest. Short positions can be taken as specific sources of absolute profit or in conjunction with a long position to hedge out a specific risk common to both positions. Many equity hedge strategists maintain a basket of shorted stocks as a hedge against a drop in the overall market. To the degree that they match their long holdings with short positions, the matched portion of the portfolio may be called WITHIN THE HEDGE. In theory, the long positions will generate profits in a rising market, and short positions will generate profits in a declining one. Therefore, for the long and short positions within the hedge, the fund manager has eliminated any systemic risk associated with the market as a whole and shifted the emphasis to the ability to pick stocks. In a rising market, equity hedge strategists expect their long holdings to appreciate more than the market and their short holdings to appreciate less than the market. Similarly, in a declining market, they expect their short positions to fall more rapidly than the market falls and their long holdings to fall less rapidly than the market. The idea is to take long positions in stocks that will outperform the market and sell short stocks that will underperform the market.
When investors borrow funds to increase the amount they have invested in a particular stock position, they are using LEVERAGE. Investors use leverage when they believe that the return from the stock position will exceed the cost of the borrowed funds. Investors who use leverage increase the risk of their investment; therefore, they usually use it only in extremely low-risk situations. Most equity hedge strategists use leverage. Leverage allows them to add new stocks to the portfolio without waiting to sell off something else first. Aggressive equity hedge managers will use leverage to move quickly to exploit investment opportunities. More conservative equity hedge managers will use leverage more sparingly, but the deployment of some amount of leverage is a characteristic of equity hedge funds in general.
Equity hedge specialists are aware that the prices of individual stocks can, and often do, move in response to factors unrelated to the direction of the overall market. Thus, if they pick their stocks well, it is entirely possible for equity hedge managers to make money on both long positions and short positions on the same day. Theoretically, they can make money in both up and down markets because they retain the flexibility to go both long and short. Equity hedge fund managers’ source of return is similar to that of traditional stock pickers on the upside, but they use short selling and hedging to outperform the market on the downside. Although equity hedge portfolios may not outperform a traditional long-only stock portfolio in a bull market, over time they should outperform the stock market on a risk-adjusted basis because they will outperform the stock market in down and sideways markets.
INVESTMENT PROCESS
Equity hedge strategists will adjust their NET MARKET EXPOSURE as market conditions warrant. In a bull market, they will try to be net long. In a bear market, they will try to have less market exposure, possibly going net short. A simplified version of the formula that they use to calculate market exposure is shown below:
For example, if a fund manager had $1,000,000 in capital to invest and borrowed a further $500,000, then if he took long positions worth $900,000 and short positions worth $600,000, the net market exposure would be 300,000/ 1,000,000, or 30 percent net long. Conservative fund managers will mitigate risk by keeping market exposure between 0 and 100 percent. More aggressive funds may magnify risk by exceeding 100 percent exposure or, alternatively, by maintaining a net short exposure. Some fund managers prefer to concentrate on stock picking and thus will pay little or no attention to macro trends. The aggregate market exposure of their portfolios will depend on whether they are finding better investment opportunities on the long or the short side. These managers take short positions primarily as opportunities to make investment returns, rather than merely to hedge against market decline. This is usually called a TRADING POSITION as opposed to a hedging position. Although almost all equity hedge managers vary the long/ short relationship in their portfolios, it is important to take note of whether market exposure is a result of hedging or trading positions.
Equity hedge strategists generate investment ideas by reading newspapers and trade journals, talking to clients and partners, attending conferences and road shows, and keeping in constant contact with industry experts. They narrow their focus to the companies with the best fundamental outlook, the best dynamic within a group of related companies, and the best investment potential on the individual level. Managers evaluate both the business and the valuation of the business in the marketplace. Before allocating any capital to an idea, most equity hedge managers make site visits to assess the energy, ability, and commitment of the company’s management and speak with competitors, suppliers, and customers to verify the company’s position within its industry. They attempt to be early in identifying economic trends that will have a major impact on the market. As with any other investment strategy, investment ideas that are not yet widely known are the best ideas. In addition, they seek an identifiable catalyst that will focus the investment community’s attention on the company, such as better-than-expected earnings or positive press releases. What does this mean for stock pickers? It means they must look hard at businesses to judge what it will take for them to succeed in the future, identify which companies have the most of it, and decide what price should be paid for the stock. In different industries, this could mean different things. It might be product development in one industry and marketing in another. In any case, equity hedge strategists evaluate companies and the valuations assigned to them. When the price and the manager’s perception of business fundamentals align, there is an opportunity to take a position.
MANAGER EXAMPLE
Williams Companies has been one of Matador Capital Management’s largest long positions since December 2002 and was one of the strongest performers in the portfolio during calendar years 2003 and 2004. When Matador Capital Management first entered the position, Williams was undergoing a major financial restructuring and was in the process of selling assets to improve its liquidity and avoid a potential bankruptcy filing. Matador Capital Management’s view at the time was that the company had a high probability of successfully executing its restructuring plan and, once completed, it would be left with very attractive assets and businesses that the investment community was effectively ignoring. When looking at the various lines of business in which Williams participated, it was possible to parse the company into a few broad segments: exploration and production (E&P), midstream, pipelines, and merchant energy. Although Matador Capital Management had a high level of conviction in the work on Williams, there was concern about broader, possibly unforeseeable industry issues. In order to protect investors’ capital against an unforeseeable industry event (much like the event that resulted in the opportunity in the first place—the demise of Enron), Matador Capital Management was compelled to identify businesses that correlated well with Williams’s various lines of businesses from a macro perspective but that were fundamentally inferior. That search led to a variety of companies, such as Dyengy, Mirant, El Paso, and others, none of which was a perfect hedge against the entire Williams position, but each of which seemed inferior to one or two of Williams’s underlying businesses (i.e., pipelines in the case of El Paso), providing an opportunity to profit on the short side, all things being equal, and to otherwise protect against a negative macro trend that might adversely impact the long holding. The end result: Williams has been a terrific performer on the long side of the portfolio for all the reasons originally contemplated and more, and various shorts have been profitable as well while providing protection against unforeseeable events. Approaching 2005, the Williams story evolved, and Matador Capital Management continued to be excited about the prospects for the company while actively hedging out the business risks in an effort to avoid that next “unforeseeable” macro industry event.1
MANAGER EXAMPLE
In mid-2003, Driehaus Capital Management began accumulating a long position in a wireless messaging company named Research in Motion, popular for its wireless email devices. It was a small company that was monitored closely since it came public in 1998. Research in Motion has several compelling competitive advantages, a superior technology with more than two hundred patents, IT-friendly support capabilities, and many carrier distribution relationships. For several years the stock did well, but the company’s device remained an early adaptor or niche market product. Then in early 2003, it combined the two key wireless applications, voice and e-mail, into one easy-to-use, almost addictive smart phone, the Blackberry. Since that time, the Blackberry has become a mass market, must-have product for business users. At the same time, Research in Motion’s subscribers, revenue, and earnings accelerated dramatically.
Subscribers increased from 534,000 in February 2003 to 1.07 million in February 2004 to more than 2 million in November 2004. Globally, the carrier’s partners have grown from twenty-five in early 2004 to seventy in late 2004, and are expected to exceed one hundred carriers in 2005. Revenue has exploded from $594.7 million in 2004, to $1.3 billion estimated in 2005, to $2.2 billion estimated in 2006. Earnings have grown from $.32 in 2004, to an estimated $2.00 in 2005, and an estimated $2.90 in 2006. Quarter after quarter, the company has had strong positive earnings surprises, and large upward estimate revisions.
Research in Motion was identified as a scaleable, sustainable, recurring revenue business model with superior technology, attacking a huge, global open-ended market opportunity. Management has executed almost flawlessly as the stock has become a huge winner, up roughly nine times since Driehaus Capital Management’s first purchase.2
RISK CONTROL
Equity hedge strategists expose themselves primarily to stock-picking risks. By doing fundamental, bottom-up research on the companies in which they invest, equity hedge managers try to avoid the disastrous state of affairs of having their long positions dropping while their short positions are rising. For those managers who carefully adjust their long and short exposures as the market dictates, there is the risk of getting caught too net long in a market decline or too net short in a market rally. Although the portion of an equity hedge portfolio that is within the hedge may approximate market neutrality, at any given time managers can lose money on both their long and short positions. The portion of the portfolio that is not hedged is, of course, susceptible to all the various caprices of the market. The equity hedge manager will hedge as many of these risks as possible with specific hedging positions. She may hedge against exposure to a specific industry by PAIR TRADING . When managers trade in pairs, they go long a stock in a particular industry and short a stock in the same industry, so that in the case of a systemic drop in the prices of the industry as a whole, the long and short positions offset each other. In addition, equity hedge managers will diversify their portfolios across industries and sectors to ensure that happenings in any one industry do not have too much effect on the portfolio as a whole.
Many equity hedge strategists use position limits to control the impact that any one position can have on the portfolio as a whole. If a position grows in market value and becomes a larger weighting in the portfolio, then they may trim it back. They will sell those stocks that reach their target valuations or those for which they lose conviction about the underlying growth qualities that originally prompted the position. When the price of a stock does not behave as expected, the manager reassesses the position. Generally, equity hedge managers are more tolerant of unexpected price moves in core holdings than in trading positions.
ADVANTAGES/DISADVANTAGES
As shown in FIGURE 5.1, the major advantage of an equity hedge strategy is its ability to hold both long and short positions. This allows the strategy to generate returns in both up and down markets. Proponents will argue that nobody knows exactly where the market is going next or why. Therefore, they will give up a certain amount of the upside to soften the blow of down markets. Equity hedge funds can generate returns that are similar to traditional long-only, stock-picking investment vehicles but with less volatility and less market exposure because of the short exposure. Equity hedge funds can generate returns that do not fluctuate as violently as traditional long-only funds. There is, of course, no guarantee that equity hedge managers will be able to achieve this. No matter how hedged, this strategy requires a manager who can pick stocks well and correctly manage the long/short mix.
FIGURE 12.1 EQUITY HEDGE
Bull markets entice many equity hedge managers to forgo any short exposure in favor of leveraged long-only positions. Bear markets have historically punished those managers who do so. To succeed over time, equity hedge managers must retain the discipline to match market exposure to market conditions.
FIGURE 12.2 shows the total strategy assets and net asset flows per year from 1990 to 2004 for equity hedge. The year-end asset total equals the previous year’s asset size plus annual performance plus net asset flows. Although performance of the strategy has been predictably solid over the years, the overall growth in asset size can be attributed to the more than $190 billion in net inflows since 1996. A key indication of the strategy’s overall impact on the hedge fund industry is the near 30 percent market share equity hedge funds held at the end of 2004.
FIGURE 12.3 on the following page shows the return distribution for equity hedge compared to the overall hedge fund industry, stocks, and bonds. Note that although the majority of the strategy’s monthly returns since 1990 have registered 0 to 2 percent returns, more than one-quarter of the months have produced returns between 2 and 4 percent. This compares favorably to the S&P 500 index, which has produced monthly returns between 2 and 4 percent only 17 percent of the time.
FIGURE 12.4 shows the average upside and downside capture since 1990 for equity hedge funds. Although the strategy outperformed the hedge fund industry as a whole during up months, equity hedge funds tend to average a loss of 0.56 percent during down months, compared to the hedge fund industry, which averages a 0.45 percent loss. And even though the strategy trails the stock market by less than 1 percent during up months, its average loss during down months is much better than the S&P 500, which averages almost 3 percent worse than equity hedge.
PERFORMANCE
As shown in FIGURE 12.5, from January 1990 to December 2004, equity hedge funds registered average annualized returns of 17.60 percent, with an annualized standard deviation of 8.93. For the same period, equity nonhedge funds registered average annualized returns of 16.37, with an annualized standard deviation of 14.29. Both groups had higher returns than the S&P 500 index of blue-chip stocks, and equity hedge funds achieved them with much less volatility. The downside protection characteristic of equity hedge funds made for slightly lower returns than equity nonhedge funds in the rising stock markets of 2003 and 2004 but more than made up for it in the falling market in 2000, gaining 9 percent while equity nonhedge funds lost 9 percent. Equity hedge fund returns are less sensitive to price changes in the overall stock market than are equity nonhedge returns, as evidenced by correlation statistics of 0.66 and 0.79, respectively.
SUMMARY POINTS
PROFIT OPPORTUNITY
• The flexibility to use leverage, take short positions, and hedge long positions is a strategic advantage that differentiates equity hedge strategists from traditional long-only equity investors.
• Equity hedge strategists combine core long holdings with short sales of stock or stock index options. They maintain a basket of shorted stocks as a hedge against a drop in the overall market.
• By having equal amounts of long and short positions within the hedge, the fund manager has eliminated any systemic risk associated with the market as a whole and shifted the emphasis to her ability to pick stocks.
SOURCE OF RETURN
• Aggressive equity hedge managers will use leverage to move quickly to exploit investment opportunities. More conservative equity hedge managers will use leverage sparingly, but the deployment of some amount of leverage is a characteristic of equity hedge funds in general.
• Theoretically, equity hedge specialists can make money in both up and down markets because they retain the flexibility to go both long and short.
• Although equity hedge portfolios may not outperform a traditional long-only stock portfolio in a bull market, over time they should outperform the stock market on a risk-adjusted basis because they should outperform in down and sideways markets.
INVESTMENT PROCESS
• Equity hedge strategists will adjust their net market exposure as market conditions dictate. In a bull market, they will try to be net long. In a bear market, they will try to have less market exposure.
• Equity hedge strategists evaluate companies and the valuations assigned to them. When price and the manager’s perception of business fundamentals align, there is an opportunity to take a position.
• Although the portion of an equity hedge portfolio within the hedge may approximate market neutrality, at any given time managers can lose money on both their long and short positions. The portion of the portfolio that is not hedged is, of course, susceptible to all the various caprices of the market.
KEY TERMS
Hedging. The taking of positions to offset changes in economic conditions falling outside the core investment idea, such as purchasing a long position and a short position in a similar stock to offset the effect any changes in the overall level of the equity market will have on the long position.
Leverage. The practice of borrowing to add to an investment position when one believes that the return from the stock position will exceed the cost of the borrowed funds.
Net market exposure. The percentage of the portfolio exposed to market fluctuations because long positions are not matched by equal dollar amounts of short positions. In general terms,
Pair trading. A long position in one company “paired” with a short position in a very similar company in the same industry.
Short selling. Borrowing a stock on collateral and immediately selling it on the market with the intention of buying it back later at a lower price.
Trading position. Opportunistic position designed to take advantage of short-term market mispricings and inefficiencies rather than hedge against market decline.
Within the hedge. Phrase used to describe that portion of an equity hedge portfolio in which long positions are matched by equal amounts of short positions.
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