RISK/RETURN

I began the virtual Hedge Synergy Fund on October 1, 2004 using a long value stock – short growth stock strategy which is essentially a mean reversion investing process. This worked rather well until July 2007. At that point everything fell apart. I then tried switching back and forth between going long and shorting value and growth, until I realized that all I was doing was jumping on the trend du jour and had inadvertently fallen into momentum investing.

Of the two types of investing, momentum and mean reversion, momentum can achieve the higher rate of return but only at a commensurate level of risk. I decided to take the momentum path because I believe it is possible to reduce that risk somewhat while still maintaining a relative high return.

There are three ways to reduce risk: varying leverage, varying the long/short portfolio ratio and adjusting portfolio beta.

Leverage is a fairly straight forward proposition. Risk is directly related to leverage; the higher the leverage the higher the volatility and the higher the risk.

Portfolio ratios on the other hand do not function in a linear fashion. If you were to start at the extreme of a 100% long stock portfolio and 0% short stock portfolio and then advance by adding short stocks while reducing long stocks until you had a 0% long stock portfolio and a 100% short stock portfolio, volatility (risk) would at first fall, hit a low point and then would start to rise again.

The long/short portfolio ratio with the lowest volatility depends on the volatility of the asset class you are using and the long and short portfolio selection process. If you change the portfolio selection process you will also change the long and short portfolio volatilities which will result in a new optimum long/short portfolio ratio. Basically, the higher the volatility difference between the long and short portfolios, the higher the long/short portfolio ratio needs to be in order to obtain the lowest overall investment portfolio volatility.

Portfolio beta is simply the sum of the beta of the individual stocks in the portfolio times their proportional weight in the portfolio. In an up market one wants be long high beta stocks (over +1.0) and short low beta stocks (below +1.0 with below 0.0 being best) with the opposite being the case in a down market i.e. being short high beta stocks and long low beta stocks.

The problem is how to transition between the appropriate high/low beta long stocks and from the appropriate high/low beta short stocks when the market changes direction. This can be done either passively or actively.

Portfolio beta can change passively through an adaptive system based on relative momentum. Just as the card count changes in Blackjack as cards are removed from the deck, so does the portfolio beta change as stocks are removed and added to the portfolio based on the momentum of those stocks relative to the momentum of the market.

Also, as in Blackjack where varying one's hand based on the card count is no guarantee one is going to win that particular hand, having a high or low portfolio beta at any particular moment is no guarantee that one will outperform the market at that particular instance. In the long run, though, one should be able to beat the dealer or outperform the market if one follows the rules consistently.

You can also actively change portfolio beta by simply altering your stock selection process. For example, one can go straight to a long portfolio beta of +1.0 by simply substituting the Vanguard 500 Index Fund for the long portfolio.

If it appears that the market has overextended itself one might wish to implement a defensive strategy instead of waiting for a lagging indicator to signal a change of action — not out of trying to predict or time a change of market direction but to limit the damage that eventually will occur when the current market trend does finally end.

One could carry out a defensive strategy by either adjusting the level of leverage, altering the long/short portfolio ratio, changing the stock selection process or a combination of all three. It is better to begin treading water if you believe the market is overvalued (undervalued) and go for a smaller positive (slightly negative) return if it prevents you from giving back a major part of your gains when the market heads down (up). This is a lesson I painfully learned in July 2007 and March 2009.

PORTFOLIOS

Both my long and short portfolios are simultaneously updated and the stocks equally weighted on the last day of the quarter. Because of net exposure and gross exposure drift I also adjust the investment amounts of the long and short portfolios at that time to bring the net exposure and gross exposure back to their initial settings (see Exposure Drift - Graph and Exposure Drift - Table).

When updating long and short portfolios during the quarter I use the closing balance of the prior long or short portfolio as the beginning balance of the new updated portfolio and then equally weight the stocks within the portfolio.

To simplify the web site updating I group the portfolios by quarterly series. I use a numbering system based on a quarterly time period with the updated portfolios within the quarter then designated by letter. For example the first portfolio of the fourth quarter of 2008 is Portfolio 18-A, the second portfolio is Portfolio 18-B etc., with the first portfolio of the first quarter of 2009 being Portfolio 19-A and so on.

UPDATING PORTFOLIOS

While a long stock portfolio can go one to three months between updates depending on market volatility the short stock portfolio should be updated every two to four weeks. There are three reasons for this.

The first is based on the fact that since the long run trend of the market is up a long portfolio of stocks, especially in a bull market, has the wind at its back and can run a lot longer than a short stock portfolio that is swimming against the tide.

The second is while the short stocks in a bear market should theoretically be helped by the downward market momentum it is not necessarily the case. This is due to the fact of the high volatility of bear markets.

The third has less to do with stock selection and performance than with the nature of long and short stock returns. When one goes long there is a positive feed back between percentage returns and absolute dollars gained or lost. If a long stock goes up, then for every given percentage increase in price, there is an ever larger amount of absolute dollars earned. For every given percentage decrease in price there is a smaller and smaller absolute amount of dollars lost.

The exact opposite happens when one shorts a stock. For every given percentage increase in price there is an ever larger amount of absolute dollars lost and for every given percentage decrease in price there are smaller and smaller absolute dollars earned.

By periodically equally weighting the short stocks, any short stocks that have been rising in price but are still remaining in the short portfolio after the update will at least have their positions trimmed back. Any short stocks that have been falling in price will have their positions increased which will help with future dollar returns if they continue to fall. In other words, when shorting stocks always add to your winners and trim back your losers.

STOCK SELECTION

“Don't gamble! Take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it." -Will Rogers

After ranking stocks by several fundamental factors, I, like Will Rogers, look for long stock candidates that are going up — I also look for short stock candidates that are going down. If, after forming the portfolios, a long stock does not continue up or a short stock does not continue down, I then — because Will’s admonishment of “don’t buy it” is not quite practical — close out the stock position and select another stock.

For further information on stock selection please see the Recommended Books web page.

DIVERSITY

It is important to have adequate diversity and liquidity. I would suggest around 50 stocks for the long portfolio and 50 stocks for the short portfolio. To maximize diversification and to minimize risk, all stocks in the portfolios are equally weighted when the portfolios are formed. The one drawback to equal weighting is that the maximum capacity of the portfolios is limited by the stock with the least liquidity.