We don’t recommend hedge funds, neither do we recommend long/short strategies.

Hedge funds are not an investment strategy. They are a compensation mechanism which provides a method to bypass the normal regulatory process governing registered investment advisors. Some, but not all, hedge funds actually hedge the market. Some mutual funds also employ a hedging strategy. The most common strategy for hedging the market is called a long/short strategy.

A long/short strategy consists of taking some portion of your investment and purchasing stocks hoping that they will go up. Generally managers presume that they have a methodology for selecting the stocks that they think are most likely to go up. That selection process normally favors purchasing “value” stocks over “growth” stocks.

A smaller amount of money is used to hedge those long investments by selling short stocks which the manager presumes are going to go down. Some managers presume that they also have a methodology for selecting stocks which they think are most likely to go down. Other times they simply short the entire market by selling the S&P 500 when they don’t own it.

Many investors don’t understand how people are allowed to sell stocks that they don’t own. Selling a stock that you don’t own is called “selling short.” Here is how it works: You borrow someone else’s stock and sell that stock at the current market price. At some later date you are required buy that stock you borrowed in order to return it. Hopefully, when you buy the borrowed stock to return it, you can buy it at a lower price because the stock has gone down in value. You are allowed “sell short” stocks or exchange traded funds. To short the entire S&P 500 you can simply borrow and sell an exchange traded fund that represents the S&P 500 such as Vanguard 500 Index Fund ETF (VOO) or iShares S&P 500 Index ETF (IVV).

Again, we don’t recommend this strategy because on average stocks go up.  If you purchase a stock “long”, you can only lose 100% of the stock. However, if you sell a stock “short,” you can lose 200% or 300% of the stock’s value if the stock price double or triples before you have to purchase it so that you can return your borrowed shares and close your short position.

Long/short strategies use the money from the stocks they have shorted to purchase extra stocks that they hope will go up. Typically a long/short portfolio might short 30% of the value of the fund to get an extra 30% cash to invest. Then they would use 130% of the value of the fund to buy stocks they hope will go up. For example, they might own $130,000 worth of stock and they might have an obligation to return $30,000 worth of stock for a net $100,000 of fund value.

If everything in the market appreciates 10%, the fund will own $143,000 worth of stock but have to return $33,000 worth of stock for a new net value of $110,000. Obviously if the long stock appreciates more than the short stock, they would make even more money. Since value stocks appreciate more than the market as a whole, investors think that a long short strategy can, on average, beat the market.

Nobel prize winning economists Eugene F. Fama and Kenneth R. French have a nice article on the Dimensional Funds website to debunk these strategies.

In short, they suggest that investing directly in a value oriented portfolio should, on average, do just as well as a long/short strategy with less complexity and less fees and expenses. Here is their explanation:

Long/Short (LS) strategies buy one equity portfolio and short another. They are often sold as a way to add a premium with special diversification benefits that arise because the premium is not highly correlated with the rest of an investor’s equity portfolio. We provide examples to show how to evaluate these claims.

Example 1 — Suppose an investor holds the market portfolio. An LS manager offers to provide a value premium uncorrelated with the market. To keep things simple, suppose shorting involves no transaction costs and can be done with full use of the proceeds; that is, there is no collateral. The LS manager provides the promised value premium by shorting the market and using the proceeds to buy a value portfolio that, like the market portfolio, has a market beta equal to 1.0. The LS strategy thus generates a value premium uncorrelated with the market return the investor holds long. To keep things really simple, suppose the long and short positions of the LS manager are equal in size to the investor’s long position in the market portfolio.

In this example, adding the LS strategy to the investor’s market portfolio is a roundabout way to get the investor to hold a simple value portfolio. If V is the return on the value portfolio, and M is the return on the market portfolio, the LS strategy produces V – M. Since the investor gets M from his long position in the market portfolio, his total return is M + V – M = V, the return on the value portfolio.

In a world without fees and expenses, it doesn’t matter whether an investor buys a value portfolio directly or constructs it indirectly with a long position in the market and an LS position that is long the value portfolio and short the market. In the real world, there are fees and expenses at every step, and if the ultimate goal is to hold a specific value portfolio, it is almost surely less costly to buy it directly from a low fee manager than via the three-step approach of the LS strategy (that is, long the market on personal account, then short the market and long the value portfolio via the LS manager). Moreover, the direct purchase approach certainly makes it easier for financial advisors and institutional managers to explain performance to clients and boards.

The example above is chosen so the effect of the LS strategy on the investor’s portfolio is transparent. The general point, valid in this and any other example we can imagine, is that LS strategies, indeed all strategies, should be evaluated on what they imply for the ultimate holdings in an investor’s portfolio and on the costs they impose on the investor.

Hedge funds using long/short strategies break at least 4 of our investing principles to safeguard your money:

1. Most investors do not understand the process and risks of shorting the market. We recommend that you only use strategies that you understand and can appreciate the risks.
2. The short portion of a long/short portfolio loses money when the stock market appreciates. Since the stock market usually appreciates, the value of a short position usually trends downward. We recommend that you only buy investments which trend upward.
3. Long/short strategies are commonly employed by hedge funds which often have lock up periods during which you are not allowed to take money out of the fund. We recommend that you recognize and avoid financial hooks.
4. Long/short strategies are commonly employed by hedge funds which often serve both as investment advisor and custodian. We recommend that you never allow your advisor to have custody of your investments.

As Fama and French concluded their article: “We end with a final statement of our general point. LS [Long/Short] strategies, indeed all strategies, should be judged by their impact on an investor’s overall holdings and overall costs.”

Photo used here under Flickr Creative Commons.