“Any time you make a bet with the best of it, where the odds are in your favor, you have earned something whether you actually win or lose the bet. By the same token, when you make a bet with the worst of it, where the odds are not in your favor, you have lost something, whether you actually win or lose the bet.” – David Sklansky, world famous poker theorist, The Theory of Poker
The Problem: The use of Exchange Traded Fund (ETFs) to hedge sector, country, or market exposure is pervasive throughout hedge fund portfolios, but their negative impact on performance is rarely appreciated. By its very definition, a hedge (like insurance) costs money. Many firms have short exposure in positive expected value ETFs to counterbalance the long exposure of individual assets in a certain sector. To compound the issue, firms are willing to take disproportionately large positions in hedges because of their perceived counterbalance to the portfolio.
How big is the impact? Take a firm that has a long position in IBM and they short the QQQQ to neutralize some of their technology exposure. Assume the QQQQ has a positive risk-adjusted return of 10 percent because the firm is bullish on the technology sector, hence the reason they are long IBM. If the QQQQ hedge is negative 5 percent of capital then it has a 50 basis point drag on portfolio risk-adjusted return. 50 basis points may be a cost the firm is willing to absorb for the hedge, but it is critical that the firm measure the impact before employing the hedge.
The Solution: In all situations, the optimal method to reduce net exposure to a sector is to find negative risk-adjusted return shorts that actually increase overall portfolio risk-adjusted return. In the absence of positive alpha shorts, the next best option may be to just reduce exposure in the long position.
If after weighing other options, an ETF short is the hedging choice, the firm should analyze the impact of the hedge by measuring its risk-reward and confirm the cost is appropriate for the risk reduction. Firms that have a repeatable decision process based on risk-adjusted return can quickly measure the impact that various hedging methods will have on performance and exposure.
Focus on the Decision Process
In a world that increasingly measures a fund based on last month’s performance, it is easy to fall victim to focusing on results and not process. A golfer should not question his skill when a good swing hits a sprinkler head and bounces out of bounds, but he should reevaluate his swing when a skulled shot hits the flag stick and drops in the hole.
There are myriad ways that a deficient process can soak alpha out of a fund and “8 Mistakes Money Managers Make” highlights only a few. Adopt a logic-based decision process that determines optimal position size based on risk-adjusted return and you will almost certainly improve your process and future returns.
Click here for the solutions to:
Mistake #1, Discounting the Downside
Mistake #2: The Good Stock Paradox
Mistake #5: Higher Return Does Not Always Mean Higher Risk
Mistake #6: What Is Your Sixth Best Idea?
Cameron Hight , CFA, is an investment industry veteran with experience from both buy and sell-side firms, including CIBC, DLJ, Lehman Brothers and Afton Capital. He is currently the Founder and CEO of Alpha Theory™ , a risk-adjusted return based Portfolio Management Platform provider.
