Thread by @hfreflection

PART 18: SHORTING

We short to generate alpha and hedge unwanted risks in longs, in a high return on time way that minimizes risk of a blow-up. This means we generally only short stocks owned by investors we can understand who we think are wrong on terms they care about. A 🧵:

Part of investing is knowing yourself. There is a good argument to be made that only shorting zeros, frauds, fads, and failures owned by irrational people produces the most alpha over time. But this is only true if you can handle the vol, which most can’t (myself included).

The risk in the HF biz is not being in business. 2020 and 2021 taught a new generation of investors not in biz for .com that the market can remain irrational longer than you can remain solvent. It’s hard to survive long/short factor mismatch over a long enough time horizon.

Most people that short junk are also value investors. This creates a factor mismatch that can crush you. Some people navigated this successfully but many did not and their funds did not survive their strategy being out of favor. Big drawdowns are the enemy of longevity.

Our short book generally matches our long book. We are short value traps, over-earners, decelerating garp, and occasionally spicier shorts in a size that matches the size of our unprofitable growth/tech long allocation. We see the following benefits of this approach:

1) alpha will be generated based on long/short spread and stock picking ability, not factor movements. We are good at picking stocks, not factors. I want to generate alpha by betting on things I’m good at and avoiding things I’m not.

3) Our strategy has a much better return on time. People who short zeros almost never turn around and go long them. Today’s over-earners are tomorrows under-earners - we can leverage our knowledge 2 ways. We also come across them more naturally while looking for longs.

4) did I say it was less stressful? I know many a manager who goes into work every day lamenting the irrationality of their shorts, even the ones who claim to be unphased by it. It’s really hard to make good decisions and focus consistently when you think the world is wrong.

5) shorts have the potential for unlimited losses and get bigger as they work against you. This is a portfolio management nightmare. One bad decision on GME, AMC, BBBY or the like can wipe out many good decisions. I don’t want to blow up.

6) it’s a lot easier to figure out when you are right or wrong and exit because you are betting on the same things. If a stock is structurally unprofitable but growing 100% you can be right that it will never make money but get your face ripped off b/c the longs don’t care.

7) the risk of this approach is you look like an idiot in 2022 for not shorting this stuff in 2021. I can live with that - there is plenty of alpha to be generated in our approach, and I’d go for doubles than swing for the fences, strikeout, and watch the game from the bench.