Hedging Life

Key Takeaways

• Hedge funds have struggled to outperform the S&P 500 over the last decade, causing them to increasingly mirror the S&P 500.

• The long-short strategy, employed by many hedge funds, provides a relatively structured framework to balance risk and reward.

• Adopting a long-short mentality in our personal decision-making can help us develop a more nuanced view of risk.

• While "bad" decisions have a finite downside, "great" decisions offer uncapped upside, encouraging individuals to take more risks, particularly early in life when potential benefits have time to compound.

Introduction

Movies and financial media have often portrayed hedge funds as the "smart money," making daring and unpopular bets on market misjudgments. Yet, over the past decade, the reality has been quite different. Outshone by the consistent performance of the S&P 500, hedge funds have found themselves increasingly migrating from their traditional methods to portfolios modeled after the S&P 500 to mitigate persistent underperformance.

Don't believe me? Consider that 92% of the top 100 hedge fund holdings from 2021-2023 were S&P 500 stocks or ETFs (see image 1).

Collectively, hedge funds have struggled with outperforming or even matching the S&P 500's annual returns over the past decade (see images 2 & 3). Although the hedge fund asset class spans a broad spectrum of holdings, strategies, and management styles, there is clearly a significant overlap between hedge fund holdings and the S&P 500 despite the consistent underperformance.

Even with this underperformance, we can still extract meaningful insights from the various hedge fund management styles. In today's blog post, we'll unpack the long-short strategy and how it could inform our personal risk management framework and decision-making process.

The Typical Hedge Fund Playbook

Despite their diversity, with over ten investment strategies employed across the asset class, 26% of the nearly 27,000 global hedge funds use the long-standing and much-favored long-short strategy.

The long-short strategy involves taking long and short positions in equities such as stocks, ETFs, mutual funds, and equity derivatives like options, swaps, and futures. In practice, this means a hedge fund might buy a specific stock, hoping for it to appreciate (aka going long), and simultaneously short or sell a different stock it doesn't yet own with the hopes of repurchasing it at a lower price, profiting from the stock's decline.

Due to the nature of long and short positions, longs have an uncapped potential upside and a finite downside, as the asset's value can only fall to zero but can rise infinitely. On the other hand, shorting assets has a capped upside— as the asset's value can only fall to zero—but carries an uncapped downside, as theoretically, the asset's price can rise infinitely.

The long-short strategy, also known as long-short equity, is the oldest alternative investment strategy, started in 1949 by Alfred Winslow Jones, the first known hedge fund manager. While the strategy isn't exclusive to hedge funds and is utilized by some mutual funds and individual investors, it's most prevalent among hedge funds due to its proven success in attracting capital, generating returns, and relatively low barriers to entry. In contrast to quantitative hedge funds like Renaissance Technologies, where barriers include technical expertise, technology, and capital, the primary barrier to long-short strategy entry is merely capital. To raise this capital, prospective long-short managers often need an independently audited track record of market outperformance and strong investment pedigree, but that's beside the point 😂.

In essence, hedge funds aim to achieve higher risk-adjusted returns than their benchmark index (the one they measure their performance against). In other words, hedge funds try to balance two somewhat opposing concepts: total risk and total return. The long-short equity strategy aims to empower hedge funds to realize long-term returns while tempering downside risk.

Long-Short Example

Let's consider a simplified hedge fund for illustration purposes. This hypothetical fund has a total AUM (Assets Under Management) of $10 million. The allocation to long and short positions is at the portfolio manager's discretion, determined by their market outlook, inherent optimism, and strategic preferences. Let's assume the fund will be 70% long and 30% short equities. This fund doesn't utilize leverage, and its investments are solely in equities, leaving out bonds, private equity, etc.

The long portion of our example portfolio is pretty straightforward - it's entirely invested in the S&P 500 ETF SPY, amounting to $7 million. Similarly, the short side is invested wholly in the Inverse Emerging Markets ETF, EUM. This investment effectively shorts the MSCI Emerging Markets Index, reflecting the exact inverse of its daily returns. For example, if the MSCI Emerging Markets Index rises by 1% today, EUM will be down by 1%. This portion represents $3 million of our fictional fund.

Considering both the long and short sides of the portfolio, $6 million of capital is market neutral ($3 million in each category), leaving the fund net long $4 million, or 40%.

As you can see, the fund is structured such that it aims to protect against some downside risk while still retaining long-term upside potential (the degree to which these two factors are balanced depends on the fund manager). Though the long-short strategy risks capturing too much downside and not enough upside, its primary function is to balance risk and reward within a relatively structured and simple framework.

By employing this two-pronged approach - strategically long and tactically short - hedge fund managers attempt to capitalize on short-term market fluctuations while benefiting from the long-term trends of earnings growth and technological innovation.

In essence, the long-short strategy provides a logical framework for hedge funds to balance the upside potential of potential winners (i.e., how much they win) and the downside potential of potential losers (i.e., how much they lose).

Sound familiar? Many of you already unknowingly implement a similar framework for making personal decisions, such as deciding whether to switch careers, start your own business, or even get married and raise a family. However, because we make so many decisions on an individual basis, we often fail to frame our decisions within the context of other decisions of ours or how they could influence our life.

Because of this, we tend to emphasize the importance of individual decisions rather than the framework, thus explaining why many of us get wrapped up in the minutia of the individual decision and our fear of failure. Instead of letting this continue unfettered, let's see how we can apply the long-short framework to personal decision-making.

The Long-Short For Life

To make this analogy more tangible, we'll equate being 'long' to saying 'yes' to life's choices while going 'short' symbolizes saying 'no.' Undeniably, both options have their role in our lives, as saying 'yes' to everything could leave us spread too thin, while always saying 'no' could result in stagnation.

Let's examine the upside and downside of risk potential decisions with an example by quantifying the five generally accepted potential outcomes of any decision; horrible, bad, neutral, good, and great. But first, let's go over a few assumptions.

First, while it's difficult to predict the probabilities of these outcomes as they are highly variable and dependent on specific circumstances, people are more likely to make neutral and good decisions than bad or horrible ones. Second, most decisions can be remediated, especially with time. Lastly, while great decisions can be elusive, they hold the potential for infinite gains if successful.

With these assumptions in mind, let's assign what we'll call an 'outcome multiplier' to each potential decision outcome. This multiplier represents the degree to which the decision impacts an individual's life (x represents the multiplication sign).

A 'horrible' decision, such as committing murder, has an outcome value of 0x, meaning you stand to lose everything. A 'bad' decision, such as bankruptcy, is less devastating but still significant, with an outcome value of 0.5x.

In contrast, a 'neutral' decision carries an outcome weight of 1x, leaving you neither advantaged nor disadvantaged. An example could be maintaining a job that you neither detest nor love.

A 'good' decision, such as relocating to a city that enhances your quality of life, promises more positive outcomes with an outcome weight of 2x. However, 'great' decisions hold the potential for limitless gain; hence they carry an outcome weight of ∞x (aka infinity). Imagine, for instance, the endless benefits of establishing a successful company or thriving relationships.

Conclusion

At this point, you are probably asking yourself, "Jack, this is great and all, but why does this matter?" While 'horrible' and 'bad' decisions have a finite downside, 'great' decisions provide an uncapped upside, just like long and short investments. This means you should be emboldened to take risks over your lifetime, especially the younger you are. You'll have more time for these good and great decision outcomes to compound, similar to the advantages of investing at an early age.

In short, this framework encourages long-term risk-taking. Prioritizing the short term excessively can lead to too many 'no' decisions, capping your downside but possibly causing dissatisfaction due to unrealized potential.

Conversely, an intense focus on the long term could have you pouring resources (time and money) into high-potential but low-success probability ventures, potentially leading to substantial setbacks and resource exhaustion. This would be the life equivalent of running out of fuel further back from where you started and having no gas stations for miles.

Naturally, people might lean one way or the other regarding risk-taking depending on their disposition. However, by adopting a long-short mentality when assessing potential decisions, we can make more high-quality decisions that fit our preferences. When a promising opportunity comes along, it's essential to run with it. Such opportunities often make up all the years of biding your time (power law in life, a topic we'll cover in a coming Randonomics post).

By implementing the long-short framework in your personal decision-making, you'll develop a more nuanced view of risk. As a result, you'll be better prepared to differentiate good risk from bad and capitalize on high-quality opportunities that come your way.

I hope you have enjoyed this week's Randonomics, and stay tuned for next week's Randonomics, where we'll consider whether salary cuts should be more widely implemented as an alternative to layoffs and how this could impact the labor market, hiring and firing costs, and more.

Thanks so much for reading, and I'll see you in the next post!

Jack Kurtz - [email protected]