The Long and Short of Long/Short Strategies by Attain Capital
One of the lasting effects of the 2008 market crisis may turn out to be the flood of assets into long/short equity strategies, which promise to give the upside of the stock market without the nasty downturns (although they don’t always deliver on that promise). What do we mean by a flood of assets…. Long/Short Equity strategies account for 35% of all alternative mutual fund assets, having brought in $35 Billion in inflows over the past 2 years. While Long/Short Equity Hedge Funds recorded their 17th consecutive month of positive net asset flows recently; with net capital allocations at US$46.9 billion year-to-date. Total assets in long/short equities hedge funds stand at $708.7 billion, close to their December 2007 historical high of $756 billion, as investors and advisors perhaps wake up to the fact that buy and hold can be quite painful at times, and a more sophisticated strategy which attempts to lessen that downside makes sense.
Fast forward to the present, and we’re seeing that same strategy of deploying a more sophisticated approach boil over from equities into commodities, which have been decidedly out of sync with the ‘commodity super cycle’ promoted by Jim Rogers and others back in 2005 to 2007. People are sick of seeing their commodity exposure do little to nothing, and exploring the idea of using a long/short approach in commodities – just as the nearly $750 Billion in long/short equity strategies are doing on the stock side.
But what is long/short commodities? For that matter, what is a long/short equity strategy. We caught up with Tom Rollinger of Red Rock Capital, who happens to run a Long Short Commodity Strategy, for some answers, and he had the following insight:
There are some big differences in Long/Short Equity and Long/Short Commodity strategies, namely that long/short equity attempts to dampen volatility and “hedge” positions via (usually, but not always) offsetting positions in similar instruments (other stocks), while Long/Short Commodity strategies also have long and short positions in different instruments, but their having long and short positions at the same time is a result of market action, not a pre-determined strategy design. In addition, any offsetting commodity instruments are usually a lot less related and a lot less likely to move in tandem. Imagine being long International Business Machines Corp. (NYSE:IBM) and short Dollar General Corp. (NYSE:DG) in a long/short equity strategy, versus long Coffee ($KC_F) and short Cotton ($CT_F) in a long/short Commodity strategy. While still two quite different companies, the former are much more related than the latter – which share almost no similarities besides being priced in US Dollars.
Long/short equity is the oldest and most prevalent alternative investment strategy. Since Alfred Winslow Jones established the first hedge fund back in 1949, equity long/short strategies have proliferated within both hedge fund and separate account structures and have more recently gained popularity with registered vehicles like mutual funds and exchange-traded funds. While there are notable differences between the various structures, these funds take both long and short positions in equities (individual stocks, options, or ETFs) with the intention of damping downside risk.
Typically, equity long/short investing involves going long (buying) equities that are expected to increase in value and selling short equities that are expected to decrease in value. Oftentimes the investing decisions are based on “bottom-up” fundamental analysis of the individual companies but there may also be “top-down” analysis of the risks and opportunities offered by industries, sectors, countries, and the macroeconomic situation. An equity long/short manager typically attempts to reduce volatility by either diversifying or hedging positions across individual regions, industries, sectors and market capitalization bands and hedging against un-diversifiable risk such as market-risk. In addition to being required of the portfolio as a whole, neutrality may in addition be required for individual regions, industries, sectors, and market capitalization bands.
[Another “long/short” approach often lumped into long/short equity category is “130/30”or short-extension strategies. These strategies start with a full portfolio of long stocks ($100 for example), take on leverage ($30 for example) to purchase additional long stocks, and simultaneously short the same amount of stocks ($30 in this example), for a total net equity exposure of 100%. ($100+$30-$30=$100.) The amount of leverage and short extension may vary (for example, 120/20 or 110/10). Because these 130/30 strategies maintain 100% net equity exposure, usually to a traditional benchmark, they exhibit correlation and beta characteristics similar to traditional investments.]
Because most long-short strategies maintain some degree of equity exposure, their performance relies more heavily on the stock market environment than other alternative strategies. Although some hedge fund managers can switch between long and short exposure, most long/short equity hedge funds and mutual funds tracked tend to stay net long. As a result of this net positive equity exposure, long/short equity strategies generally remain highly correlated with equities.In general, good environments for long/short stock-picking strategies are ones in which stock markets are trending up but with significant dispersion among stocks, within and across sectors and geographies.
Unlike equity long/short strategies which aim to hedge positions in an attempt to dampen volatility, the predominant Commodity Long/Short index, the Morningstar Long/Short Commodity Index, employs a momentum-based, directional outright position methodology to generate alpha with no attempt to hedge. Morningstar was accurate in observing that, due to the fundamental mechanics of how futures markets actually operate, “long-only” commodity indexes are at least somewhat flawed in design and a suboptimal choice for investors’ capital.
This is because hedgers, who utilize the commodity futures markets as a means to transfer price risk to speculators or investors, could be ‘producers’ or ‘consumers’ of various commodities and, depending on which one they are, could benefit from the price of that commodity either rising or falling. This means that while the net supply of commodity futures contracts may be a “zero sum”, there is more to the story, since one group of participants (hedgers) is regularly willing to pay a premium (i.e. initiate and hold losing positions) to limit their risk. Producers of commodities are able to hedge their price risk by taking short positions in futures contracts on the commodity that they produce. Conversely, consumers can hedge their risks by buying long positions in the futures contracts on the commodities that they consume.
Morningstar created a set of single-commodity indexes to serve as constituents for the Long/Short index by calculating a “linked” price series that incorporates both price changes and roll yield. The weight of each individual commodity index in the Long/Short index is the product of two factors: magnitude and the direction of the momentum signal. They initially set the magnitude based on a 12-month average of the dollar-weighted open interest of the commodity. They then cap the top magnitude at 10% and redistribute any overage to the magnitudes for the remaining commodities. The direction depends in part on the type of composite index and in part on the type of commodity in the Long/Short index.
In the Morningstar Long/Short Commodity Index each month, if the linked price exceeds its 12-month daily moving average, the index takes a long position in the subsequent month. Conversely, if the linked price is below its 12-month moving average, the index takes the short side. An exception is made for commodities in the energy sector. If the signal for a commodity in the energy sector is short, the weight of that commodity is moved into cash; that is, the index takes a flat position.
This is a simplistic long/short commodity model, similar to the traditional systematic trend following type models which bracket markets and enter long or short when prices break above or below 1 or 2 standard deviations of recent price activity. So, in many ways, traditional trend following/managed futures type strategies are doing some long/short commodity type trading already.
However, due to their size, the majority of the largest and most popular systematic trend-based CTAs only offer 25% exposure or so to commodities with the rest of their trading occurring in financial futures such as currencies, fixed income, and stock indices. Part of the motivation behind the ‘long/short commodity’ naming convention is that the newer wave of tactical commodity program managers and indexes want to make sure that they are noticed for their 100% exposure to commodities.
Our own strategy, the Red Rock Capital Commodity Long-Short Program, utilizes proprietary measures and combinations of volatility and price discovery in an attempt to capture directional alpha while trading 29 commodity futures markets either long or short. Originally we referred to the program as the “Commodity Long/Short” program, but for reasons outlined above – felt some people were confusing it to be too similar to an “Equity Long/Short” strategy in design – which it is not.
P.S. – Check out Red Rock’s whitepaper on Long Short Commodity strategies for more information.
“The Managed Futures Blog is a compilation of thoughts, research, attempts at humor, and more from the team at Attain Capital Management (“Attain”). Attain pairs high net worth individuals, RIA’s, and institutional investors with alternative investments in commodities, managed futures, and global macro strategies through privately offered funds and managed accounts. Click here to sign up for their insight and analysis.”