2 May, 17 tweets, 4 min read
How to manage a l/s portfolio 101. For all the messages and DMs everyone has had asking clarifying q’s on l/s spread. Here is a way too long one stop answer.
There are 4 sources of L/S performance: long, short, gross and net.
The majority of funds earn a much higher % and \$ alpha on longs, than shorts and they also have no idea how to flex their gross. I don’t view net as a source of alpha. Some do. I view it as % of beta capture
Long alpha is the excess return of your longs over the mkt. Short alpha is the underperformance of your shorts v the market.
Mathematically if your longs and shorts both perform in line with the mkt, your spread is 0 and your return is just a function of your net * the mkt because of the 0 spread. A higher or lower net is just a higher or lower % capture of the mkt return.
For example longs ⬆️ 10, shorts ⬆️ 10, mkt ⬆️ 10 = 0 spread
120 gross long - 80 gross short = 40 net * 10 mkt = 4% return
130 gross long and 70 gross short = 60 net * 10 mkt = 6% return
Higher gross long in up mkt = higher % return.
Inverse for lower mkt.
It’s captured.
Within all sectors the top 3 deciles o/p the bottom 3 deciles by 25-30% on avg over 20 yrs.
If you can capture o/p longs and u/p shorts you can generate 20-30 spread.
It is what it is yr to yr.
Ex 1 - Longs ⬆️ 20%, shorts up ⬆️ 5, mkt ⬆️ 10 == 15 spread, 10 of long alpha and 5 short alpha.
Ex 2 - Longs ⬆️ 15, shorts 0, mkt ⬆️ 10 == 15 spread, 5 long alpha and 10 short alpha.
Ex 1 if you run 120 long v 80 short so 40 net your longs are ⬆️ 24 (20*1.2) and shorts are ⬆️ 4 and 15 spread equals 20 total return
Ex 2 run same gross and net. 18 total return.
15 spread but different returns? Why? Lower long alpha on high gross long
L/S becomes a sprint b/c of shorts and leverage. For example -
Longs ⬇️5, shorts ⬆️ 5 == negative 10 spread on 220 gross/60 net = capital ⬇️ 11%.
No bueno.
Capital was 100 it’s now 89. LONGS DOWN, SHORTS UP,
GROSS was 220 and IS NOW 245.
Yikes what do I do now?
How to optimize? Being too long term focused in this model hurts. The job is not just to find LT great longs and shorts, but to bet on how they will interact with one another in the ST.
Try to play L/S likes it’s an infinite game and you’ll discover it’s finite real quick.
How to optimize?
IMHO -
Mkt goes up over time.
Easier to scale long alpha.
Long bias on modest leverage produces higher returns than 0 net on high leverage.
But those drawdowns!! Damn.
Take your gross up and down like an accordion when odds seem good.
Funds should be 100+ gross long imho. Why? Longs are best ideas so why have a fund with less than 100% in my best ideas? The absence of short ideas should not cut into long gross exposure IMO. I’d rather have a high net if I have great longs regardless of my shorts.
If you can generate 80-100% exposure in shorts that add even a little alpha then being long 130-140% for a 230% gross & 45-50% net is sweet spot imho. It maximizes ROE on a good ROA.
I want the 30-40pct amplifier on my longs.
If you can find 100%+ in short exposure I’d still hesitate to go that high unless I was close to 0 net b/c of upside vol.
On the flip side, if shorts are sub 40 and longs are sub 100 so you run 85 by 35 for 120/50 I don’t think you are optimizing the model.
If my unlevered long book compounds at 20 why would I convert 80-85pct of that into profits rather than 130-140pct? What exactly would I be optimizing for in that scenario?
Summary
Gross exposure and longs are highest alpha generators.
220-240 gross by 40-50 net is sweet spot target exposure when odds are favorable.
100+ gross long is optimal.
Sub 140 total gross is sub optimal.
Flexing between 140 and 240 gross optimizes the model.
In the end everyone has to know themselves and the game they are playing. There are many different ways to run a l/s fund and AUM can influence strategy. The above is simply my belief and experience for how to best optimize the model for highest possible returns per unit of risk.

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# More from @pmje73

18 Apr
This discussion around the old mutual best idea fund is also interesting because I only act on what I consider to be my best ideas. A portfolio is a collection of my best ideas. Marginal ideas don’t ever get in the portfolio without a thesis even if they are a “great business”
The way I become concentrated is not by intentionally targeting a specific number of ideas. I work on as many ideas as I can, I subtract the marginal ones, I size the great ones and I constantly look for better ones.
If a great business becomes a marginal idea I am working diligently to find a new angle to keep it and refresh my thesis or replace it with an equally great business that is also a great idea. And round and round I go.
10 Apr
Broker 101 - Prime Brokers serve institutions ie hedge funds and primarily make money two ways - lending you \$ against your capital and charging a vig or charging a fee to locate owners of stock willing to let hedge funds borrow their stock to sell short.
Long only institutions are major clients of PBs also through the volume of trades they do given their enormous asset base. Those trades make MFs big clients to trading desks.
Since both of these functions are volume and fee based the bigger your AUM and the more you borrow or transact the better client you are to the fund.
8 Apr
So you want to be an emerging manager? (Warning this is long)
Why should you care about what I have to say? I worked at a h/f that specializes in developing portfolio managers. I was there as the fund 10x and started 2 new strategies.
4 and soon to be 5 of my former analysts have their own funds. I have worked with a few emerging managers not from my old firm one of whom has improved performance materially and tripled aum since we started working together and one who has risen to over a bn of aum.
6 Apr
I am very strong believer in one person being responsible for PM decision for a couple of reasons.
I believe portfolios require active management and monitoring. Groups can’t do that, individuals can.
I also believe group decisions create conflict. Not in the deciding but in the evaluation of who deserves credit/blame for the outcome. Worked out great it was my idea. Not so much then it’s on you.
24 Mar
Investing in controversial stocks is a bit like being a lawyer. Knowing whether you are the prosecutor and have to prove something or the defense who can sit back and see if the prosecution fails to make its case.
Intel just flipped its narrative. If you are bearish you now have to prove Gelsinger’s plan won’t work. Will be a long while before you’d have to prove that it actually will work.
These moments usually cause major sentiment shift in a stock.
21 Mar
A lot of observations out there about how difficult YTD has been for l/s funds. That’s because 2020 was a historic year for dispersion between winners and losers both quantitatively and qualitatively.
L/s spread can’t be created. It has to be captured. Sometimes the fish jump in the boat like 20. The spread available to l/s managers was more abundant in their preferred style than they could ever imagine and all they had to do was sit tight and let the fish jump in the boat.
Spread opportunity is mean reverting. Meaning over time even if great businesses outperform crappy ones, they may not for long periods of time and not likely after a massive period of positive dispersion.