Sunday, October 31, 2010

Risk Reduction is Risky in the Long-Term

We can and should learn from every day of our lives. For those of us that are addicted to the securities markets, non-holiday weekdays are our primary classes. The markets of 2006 through 2010 were extremely difficult for all of the students and quite a number failed to finish. One might call these years a master class. However, very few of my fellow students could be awarded a Master’s Degree for the investment progress they achieved. The reason for the lack of success was not that the period did not offer ample opportunities to achieve some large gains as well as some startling losses, but it was difficult to link the periods where the net results were positive for those invested in equities.

Shorting successfully is difficult over time

The intellectual foundation of hedging initially is that carefully chosen securities will go down more than equally carefully selected securities would go up, so that the net result should be to preserve the larger gains of one’s purchases. The truth in the matter is that shorting is difficult to do well over long periods of time. An examination of various shorting approaches will identify the problems that might occur.

Sell the Frauds and the Fads

Until tried in a competent court of law, (and perhaps not even then) it is difficult to have absolute certainty from the outside that some action is clearly fraudulent. Even with the best forensic accounting practices applied to public financial statements, one can not be sure that there is a fraudulent intent. As we have seen in the Madoff and other cases, guessing when the various authorities will surface a complaint, let alone a conviction of fraud, is difficult. (Please do not confuse intellectual frauds when someone should know that what they are saying is wrong, with the intent to deceive through the use of fraudulent financial statements. Over time, intellectual frauds are dealt with in the market place and not a court of law.)

Throughout history there have been brief periods when a large portion of a population becomes enticed into certain actions, usually purchasing, some object or service of questionable utility. For the more senior members of this blog community a good example would be Hula Hoops. When rotated around one’s body, these plastic hoops were meant to aid in fat reduction and other health and psychic benefits. As only the young seemed to have hip movements that could keep the hoops from falling to the ground the fad died out quickly, but not before there were a few stocks that successfully touted these wonders. (From a potential short seller’s position, it is important to distinguish the difference between a relatively short period of a fad that has no lasting value from a fashion that may last for awhile. Both Nehru and Mao jackets did provide some continuing clothing benefits.) The most successful managers of short selling funds are expert at these two approaches. However, even with their clear insights they do not produce winning results every year.


As an analyst, I used to recommend to some hedge funds that they invest in pairs of somewhat similar securities, with the strategy to purchase one and to sell the other short.

One example of this was to recommend for purchase an aerospace company who, in my opinion, was most likely to win a multi-billion dollar defense contract and to short the expected loser. The key to this strategy was not to stay too long, actually it worked best on the day of the announcement. By the time the earnings were expected to be generated by the winner, there was likely to be a recognition that the winner bid the contract at too low a price and would only become significantly profitable from change orders and possibly spare parts reorders. The loser was often free to position itself for the next exciting contract. A somewhat similar pair bet was available every autumn, focused on the Nielsen ratings for television programs. As NBC was buried within RCA, the choice was between CBS and ABC. There have been other event-oriented pair bets. More common is to focus on two large companies within an industry and buy the better-quality company and short the lower-quality company. The only problem with this strategy is that since the bottom of the stock market in March of 2009, often the lower quality stock did materially better than the high-quality competitor. (I am not hearing many pair recommendations either as stocks or as fund formats recently.)

Sector ETF bets

According to the Investment Company Institute (ICI), approximately 20% of the dollars in Exchange Traded Funds (ETF) are in sector or industry funds. Making judgments on sectors is very common today as described in the reports issued by mutual funds and other institutional funds. The funds that make sense to me are those that most of the time select individual stocks that do better than their sectors. Taking this approach further, one could suggest shorting the sector ETF. The problem with this approach is that often the ETF has more low quality names in the portfolio than the individual stock selected. As I have commented above, we have been in a period where the low quality stocks, with their bigger perceived potential, have performed better than the perceived higher quality stock chosen. I suspect that an uncomfortable portion of the transactions involved with ETFs are part of short trades or at least leverage transactions. If I am accurate, this may suggest that a new element of volatility has been introduced.

Market Timing/Macro Investing

The only thing more dangerous than guessing which way the market will go correctly one time is guessing correctly twice. By the time one does it three times in a row you convince yourself and others that you are expert. There are a very small number of professional money managers who do have a record of guessing the overall market trends effectively. Some of the best of these run Macro hedge funds which make big bets through derivatives and other forms of leverage on the sequential changes in direction of the major markets around the world. (I wonder if one made an equal size bet on every Macro fund that began each year and compared its average performance over the next ten year period to that of a collection of broad market indices (adjusted for country bets) which would win? This is not to deny that there will likely be a few spectacular winners, but many won’t finish and therefore for this exercise, they would be declared losers.) Those who are even less successful are called market timers. There is a long history, both at the individual and the institutional levels, as to the lack of success of market timing. Long-term faith in the belief that the trend is one’s friend does not have good results in the stock market, but could in the commodity markets.

Owning Winners

As strange as it seems, one of the best risk reduction approaches is to attempt to own only long-term winning stocks and to accept periodic volatility. (I must admit that it is with difficulty that I attempt to follow this precept.) The concept is one of muted optimism; that throughout our lives there will be an upward bias to stock prices. If one takes the absolute opposite point of view, one believes that long-term bouts of sitting with cash and very high-quality short-term instruments with occasional forays into the market is a correct strategy. Using the Dow Jones Industrial Average as an equity market indicator, in the past we have suffered flat periods of sixteen years and we are in an eleven year flat phase now. I believe that we will breakout on the upside eventually, at least in nominal dollars. And that is how I bet. Each year those that attend the annual meeting of the Board of Trustees at the California Institute of Technology (Caltech) participate in a contest to guess what the DJIA will be selling for at the next year’s meeting. I will almost always be betting for a significant advance because it will happen at some point.

The best way to avoid losing is to Win.
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