Long Short Investment Strategy – What It Is, How It Works, And Why You Should Care

 

A long short investment strategy may provide investors the key to a successful portfolio in secular bear markets (such as the current market and 1966-1982).

The History of Long Short Strategies

The long short strategy dates back to 1948 when Alfred Jones, a Harvard graduate and former U.S. diplomat, also known as the “Father of the Hedge Fund”, set forth to try to minimize risk in holding long-term stock positions by short selling other stocks, therefore “hedging” risk.

This investing innovation is now referred to as the classic long short equities model or the “Jones Model”. Jones also employed leverage in an effort to enhance returns.

However, previously implementation of this strategy had been much more complicated than the explanation above, especially back in Jones’s day. However, during the last few years innovative companies, such as Rydex and Proshares, have created index ETFs (exchange traded funds) that will go both long and short – and even ETFs that will do so with leverage.

Why Not Just “Buy And Hold”?

You might be saying, “I’ve always thought that if you diversified enough with investments that are non-correlated, that you would be okay in a bear or bull market?”

Well, partially that’s true. However, go back to 2000, 2001-2002, and 2008 mutual funds that had an objective of Growth, Growth and Income, or Aggressive Growth, had substantially negative returns – diversified or not. Furthermore, you can over-diversify to the point of neutralizing your portfolio to where it’s not going to perform well in either a bear or bull market.

However, because buy-and-hold is easier and has been established by the industry, many financial advisors and investors alike have just resorted to “dumbing down” their portfolios, knowing that they are giving up significant returns in a bull market, just to not get “wiped out” in a bear market. That may be the simplest approach, but I’m not sure that it’s the most efficient.

How about placing more bonds in the portfolio? “I always thought that if I put enough bonds in my portfolio, that they would move up when my stocks moved down?” Well, that may be partially true, but there are certain business cycles and market circumstances where stocks and bonds both move in the same direction.

Furthermore, bonds that normally range in single digit returns are not much of a match to equities which in a volatile bear market can fall 20% to 80%. Tossing a glass of water on a raging forest fire has little effect.

For example, a typical Moderate Growth portfolio with a 60%/40% Equities to Bonds ratio saw a negative drawdown on average of over 33% during the bear markets of 2000-2003. Therefore, we need to find something more predictable that corresponds in equal strength of movement than bonds.

How Long Short Strategies Work

What seems to make the most sense to me is a system that would equally benefit from either a bear market or a bull market. The most straightforward and simplest method that I am aware of to accomplish that is a long short hedging strategy.

Long simply means that when the market is anticipated to be in an up-trending phase, investments are made that move in the same direction as the market (i.e. index ETFs).

However, when the market is anticipated to be trending in a downward phase, those long investments are replaced with short investments, investments that move in the exact opposite direction of the market (i.e. Inverse Index ETFs). The perfect non-correlating asset is the INVERSE of the asset itself!

The result, simply put, is that you have an equal opportunity for your portfolio to increase in value, regardless of whether the market is consistently trending UP or DOWN.

Best Type Of Account Structure SMA Or Mutual Funds

“So I should just buy a long short mutual fund, right?”

Not so fast, mutual funds have numerous limitations that can hurt the performance of a long short strategy. The majority of mutual funds have restrictions on how much cash they can raise and need to deal with investor withdrawals during bad markets.

A better solution is to use a separate managed account structure – where the investor’s money is held in its own, separate account:

Where Does It Fit In My Portfolio?

Developing a successful system to decide when to go long and when to go short is no easy task. Therefore, the industry is to some extent right, even though it is also somewhat self-serving, to warn the general public and most financial advisors not to time the market but to just leave their investments fully invested at all times.

However, it’s ludicrous to say that mutual fund managers and professional money managers do not have methods of timing their investments. Market timing is an integral part of professional money management.

Long short strategies are available at various risk levels, however I feel that a conservative, long term, long short strategy is best when used as the core or “backbone” of an investor’s portfolio. Once the core is in place and investor can use other investments to make the entire portfolio more or less aggressive.

Why Should I Care?

Why bring this up now? The average economic cycle since 1854 was just 56 months and the median 44 (30 months of expansion and 14 of contraction). Source The Economist, Deutsche Bank

While, the start of recessions are declared well after the fact, the median average means the US is about to start another down cycle. And many economists are seeing warning signs.

Perhaps Ben Bernanke and the Fed will be able to extend the cycle longer, but many are starting to worry that they are running out of ammo. In addition China is slowing down and Europe just officially announced that they are in a recession:

The Business Cycle Dating Committee of the Centre for Economic Policy Research (the European counterpart of the U.S. NBER) last week issued a declaration that Europe entered a new recession a year ago, dating the business cycle peak at 2011:Q3

Europe Has Entered A Recession

GDP Europe

Even if the Fed’s QE policies can extend our current cycle, global markets are sure to become more volatile and will impact US markets – providing long short investors an opportunity.

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