Investment: Long/shorts need rethink

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By:
Helen Avery
Published on:

The losses in the long/short strategy favoured by the majority of hedge funds show no signs of abating.

 In October, the HFRI long/short index (equity hedge) was down almost 8%, taking the year-to-date loss to 22.5% compared with the weighted average of 15.5%. Almost $30 billion has left long/short equity strategies this year. HFR estimates that there is about $516 billion in long/short funds, down from $684 billion at the end of 2007, including asset loss through performance.

"The myth that one could produce on the upside while fully protecting the downside has been busted"

Harry Rady, Rady Asset Management

But is it the end of the long/short strategy? Harry Rady, CEO of Rady Asset Management, says it is not but believes the investment approach used by long/short managers will have to change. "The days of the highly levered, hyper-trading, blackbox models are over, and the myth that one could produce on the upside while fully protecting the downside has been busted. We’ll see a return to the old-fashioned way of buying stock that is undervalued and holding those over time to let the value be realized." Rady’s fund typically waits to buys stock when it has dropped by at least 50% in value. "We don’t want to catch a falling knife, so we wait until we believe all the bad news has been priced in and the stock has levelled off." Rady says all too often managers see a stock where the company has positive fundamentals and jump in when the stock is trading near its 52-week high instead of waiting before buying for it to come down and be undervalued. "There are thousands of cheap companies out there right now, but most look like value traps and may well be staying cheap for a long time," he says.

Finding companies whose stock will rise in this environment is not easy, adds Rady. "Multiple expansion is unlikely – specifically, P/E ratios are not going to increase much over the next few years for most companies. So the only thing that will make the stock price increase will be earnings growth. It’s extremely difficult to find companies that will have earnings increase in this environment." Non-discretionaries, such as food, medical equipment and pharmaceuticals, are sectors that are more likely to house such companies.

If going long is difficult in this market, going short is harder still, says Rady. "There is so much bad news discounted in already that the slightest bit of good news drives a rally, so it’s dangerous to have a lot of shorts on. Those pessimists out there with a disproportionate amount of shorts on are likely to get hurt." Somewhat counter-intuitively, Rady recommends that the best short play is on companies with high expectations. The slightest bad news from the market and the stocks at a premium will drop more than the average stock. "That way I only have to have 25% of the portfolio short as these names typically drop twice as much as the market and fare even worse with a little company-specific bad news," he says.