3 RULES
While on vacation in August of 2011, I came up with the following three rules. These rules form an adaptive stock selection process and will automatically vary net exposure based on market conditions. I realize they seem very simplistic — but when it comes to investing — I find it best to try to keep things simple.
RULE 1 – Stock Selection
Select long stocks that are outperforming the market and short stocks that are underperforming the market.
RULE 2 - Exit Strategy
At set time intervals, remove a given percentage of long and short stocks that are not meeting your expectations and replace them with stocks from Rule 1.
RULE 3 – Risk Management
You should try to limit losses by periodically adjusting the ratio of the long portfolio to short portfolio based on the betas of the long portfolio and the short portfolio so as to try to break even if the trend reverses.
In executing Rule 3 you need to keep in mind that you do not need to equal or exceed the up-market’s return. Even if you capture less than the up-market’s return but are able to break even or perhaps capture some of the down-market’s inverse return, you can still make a long-term rate of return that far exceeds the market’s return (please see Ed Easterling’s article “Rowing vs. the Rollercoaster”).
For further information on stock selection please see the Recommended Books web page.
PORTFOLIOS
I try to update the stocks in the long and short portfolios approximately every two weeks. I usually adjust the ratio of the long portfolio to short portfolio at the end of the quarter, though, if I believe it is warranted, I will adjust the ratio of the long portfolio to short portfolio during the quarter.
When updating the stocks in the long and short portfolios 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.
REGULATION
Because of the advent of stronger regulations by the SEC and an increased demand for information and transparency from institutional investors, it is essential to have the proper procedures in place to handle the increased paper work and regulatory requirements. That is why I believe very strongly in using an outside administrator who has the experience and expertise to handle this fast changing environment. A Hedge Fund Manager should spend his time analyzing stocks, not expending time and energy on office management. Those tasks should be delegated to others by the Fund Manager (see Administration).
HEDGE STRATEGY (October 1, 2004 to May 16, 2008)
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.
The following link is to the "Time-Blended Portfolio" web page which explains my portfolio management strategy from October 1, 2004 to May 16, 2008. (Time-Blended Portfolios).