Soon after our recent commentary on investing in stocks when risk appears to be on the upswing, the annual investor letter from Seth Klarman—CEO and portfolio manager at Baupost Group—started to make the rounds on Wall Street. In it, Klarman, 61, manager of roughly $30 billion in assets, expressed concerns right now about increasing risks around the world.
Record government debt and the idea that investors aren’t factoring in the long-term repercussions of increased political instability are weighing on his mind. Today is giving rise to new types of leaders who profess less interest in global cooperation. This, in turn, risks disrupting global trade networks that have slowly been built since World War II.
With approximately 43% of sales to S&P 500 companies taking place in international markets (according to S&P Global Intelligence data), there’s little question that a large driver of the ascendance of the S&P 500 has been international trade. Start to chip away at that, and you fracture one key reason stocks have risen. Plus, an equity investor’s worst enemy is declining earnings per share.
Add to this that CFOs at public companies generally hate uncertainty, so if their confidence is flagging, they often seek any excuse to not spend more money. This means we risk a self-fulfilling economic slowdown if the scent of uncertainty lingers too long in the air.
Although we are long-term investors focused primarily on owning companies we believe will reward us over the years, today’s changing environment suggests extra due diligence on the risk side of the equation. After all, following a 10-year bull market, most of the best stocks on the market do not look inexpensive, and even the best stocks typically suffer when the global economy slows.
So what can we do to manage for growing risks while remaining committed, long-term investors who seek to compound our capital?
Many hedge funds—even ones that have had some good years—place large, often lopsided, bearish bets. Some famous fund managers have shorted Tesla (Nasdaq: TSLA) and Netflix (Nasdaq: NFLX). With bold, high-profile shorts in place, a manager can claim to be hedged (and may even believe they are). In many cases, though, they’re anything but hedged. Investing against dynamic companies is perhaps one of the worst ways to attempt to hedge portfolio and market risk. And gives hedge funds a bad name.
For one, such positions are not aligned to be protection against the market falling. In some cases, they’re little more than bets that the market will be proven wrong on one popular stock. For another, high-profile shorts pressure the manager to not capitulate under pressure, perhaps compounding the losses as they grow. You should leave your ego at home when investing, and that’s especially true when you’re selling short.
So, it’s a wonder to us that more hedge funds don’t run large, boring, deeply-diversified baskets of shorts, with very small positions in each individual company. By shorting struggling, mid- to large-sized companies, one stands to capitalize on the history that shows a majority of stocks lose value over the years. This means shorting many laggards seems more logical than targeting a few highfliers.
As history has also shown, a short seller can return 30%, 50%, or more shorting the likes of IBM (NYSE: IBM) or General Electric (NYSE: GE) when these giant companies’ fortunes are flagging. So, why risk large losses, high fees, getting called out of your short early, or whipsaw volatility just to potentially make the same sort of return shorting Tesla or Netflix?
For investors looking to hedge, shorting recognized laggards seems to hold more logic than shorting a company that’s changing its industry and has the flying stock to prove it. We’re in this camp. We want to short large baskets of debt burdened, competitively-challenged companies that are being left behind by the world, and that face an uphill battle to change that outcome.
But even this approach does not guarantee extra profits in your portfolio when the stock market falls. Sometimes past laggards perform relatively well in a falling stock market. So, we also want to maintain relatively simple—but timely—hedges on select market indexes using options or index shorts. This way, when the market falls, we know these inverse market positions will be moving toward the green for us, potentially giving us more money to invest in beaten-down stocks as we close successful hedges.
In sum, we believe that an investor with ample experience to merit researching and selling shorts, and with time to manage the positions along with options, can stay invested in strong companies but reasonably manage risk by:
- Managing a sizable basket of shorts alongside their longs, usually twenty shorts or more at around 0.5% to 1% in size each, and steadily refreshing the basket with new positions as needed, while capping losers and taking gains on winners.
- Maintaining market index hedges as well, with options expiring in various months, and sometimes direct shorts of market indexes, large enough in size to matter, but structured or protected so the hedges won’t notably drag on the portfolio’s results in a rising market.
- Maintain a focused portfolio of long stocks in which you believe strongly. Don’t own ones that don’t make the “quality” cut. These positions are meant to compound your returns, so they better be strong.
So, one can be as invested in long stocks as wished, but also sleep well at night knowing your short basket will likely help in a decline, and you carry positions on market indexes that will profit during a market decline, too. This complete approach takes more work and time than does the “easy” decision to short a Tesla or a Netflix, but we believe that it has the potential to work much better. It’s a “whole portfolio” approach, and it can prove fruitful even before using options to make extra income and other returns on top of this, too.
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The content in this message is provided for informational purposes only, and should not be relied upon as recommendations or investment advice. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues. The mention of specific securities does not constitute a recommendation with respect to these securities.
It is not possible to hedge fully or perfectly against any risk, and hedging entails its own costs. The success of hedging strategies depends on your ability to correctly assess the degree of correlation between the performance of the instruments used in the hedging strategy and the performance of the investments in the portfolio being hedged. Since the characteristics of many securities change as markets change or time passes, the success of hedging strategies will also be subject to your ability to continually recalculate, readjust, and execute hedges in an efficient and timely manner. A short sale involves a theoretically unlimited risk of an increase in the market price of the security sold short, increasing the cost of buying those securities to cover the short position, and thus a possible unlimited loss.