THE AWM LONG-SHORT EQUITIES STRATEGY

This strategy dates back to the very earliest days of stock market investing and is one of the original hedge fund strategies, though short-selling it has been in existence since at least the early 1800s.

The first known hedge fund was created by Alfred Winslow Jones in 1949, although the modern hedge fund industry has only gained wide-spread popularity within the past twenty years or so. Hold both long and short stock positions within the same portfolio provides a hedge against declines in the overall market, and opportunities to profit from both bull and bear market conditions. It can be combined with The AWM Fixed Income Strategy to create a Balanced portfolio, with The AWM Long-Short Equities Strategy substituted for the normal equity allocation. One way to think of this approach is to look at the long-only approach as only half of the total opportunities available in the markets.

Selling-short allows the portfolio manager to take advantage of both overvalued securities and overall sector and / or market corrections. With a long-only strategy, especially one that uses a buy-and-hold approach (buy and forget with many investment firms), the manager is unable or unwilling to take advantage of short-term corrections, overvalued securities, or longer-term bear markets. The most the manager can do is to raise cash and wait for better times and better valuations before once again buying long. This problem is particularly acute with regard to buy-and-hold strategies, because the manager, even if they believe stocks to be seriously overvalued, can do nothing, not even sell positions and raise cash, but stay the course and hope that better times return.

Too often, gains that took years to accumulate in the buy-and-hold strategy are given back within a very short time frame; sometimes within weeks or even days. It is precisely because of this fact that the vast majority of buy-and-hold strategies underperform their benchmarks, even when the manager has made good decisions and has made sizable profits during bull market phases.

One way to look at adding short-selling to an investment strategy is to think of the long-only strategy as two dimensional (long or cash), and at the long-short strategy as three dimensional (long, short, and cash).

The AWM Long-Short Equities Strategy combines long positions, short positions, and cash balances, and incorporates everything we have learned in eighteen years of investment experience. An extensive analysis of all global economic and financial factors is conducted on an ongoing basis, to identify macro and micro trends. Sectors are then identified, which we feel will either benefit from trends (for long positions) or that we feel will suffer from trends (for short positions).

Within each sector, industry groups, and then individual stocks, are then selected that we feel will be the best vehicles to generate profits from these future trends. Long positions are selected using the same comprehensive fundamental and technical analyses used in The AWM Long-Only Equities Strategy. For short positions, we are basically looking at the same fundamental and technical factors that we use for The AWM Long-Only Equities Strategy, but in reverse – that is, we identify those stocks that exhibit the most overvalued fundamentals and the most technically overbought characteristics, in those sectors that we feel represent the most unattractive fundamental and technical characteristics, given our analysis of, and expectations for, future macro and micro global trends.

By combining both long and short positions within the same portfolio, we accomplish two complimentary goals: First, we are able to take advantage of both bullish and bearish trends, and both overvalued and undervalued individual stocks. Second, by combining long and short positions, in most cases, overall portfolio risk is reduced.

One can define risk in many ways. In this context, we define risk as the volatility of total portfolio value over time. One might define risk as the probability of losing money, a definition of risk that many individual investors prefer. If this is the definition of choice, we argue that in most cases, having short positions in portfolios reduces losses in down-cycles, in corrections and in bear markets, when compared to long-only strategies.

As individual portfolio characteristics vary widely, it is difficult to make a blanket statement that all hedged portfolios will lose less than all long-only portfolios in all market conditions. We do not make this claim. However, in general terms, we feel that a hedged portfolio is superior to most long-only portfolios in terms of reducing downside risk in down markets. Now, when talking about beta in the next section, we are only dealing with systematic or market-specific risk, and not with company-specific or non-systematic risk.
Anyone reading this who has studied financial markets and portfolio management will understand that there are additional factors to consider when investing real money. But for our simple example, I am trying to explain hedging in its simplest terms, so please bear with me.

Here is a very simple and simplistic example, but it should help to illustrate the added benefits of having short and long positions within a single portfolio: Let’s say you have two stocks in a portfolio; one long and the other short. Let’s also assume that each stock has a beta of one (beta is a widely used and accepted measure of volatility.) The market (S&P 500) is always assumed to have a beta of one, so our assumption in this hypothetical example is that each of the two stocks also has a beta of one.

If within this hypothetical portfolio, we have an equal amount of dollars in each stock, for any given movement of the overall market, the portfolio will stay exactly even. This is because as one stock moves with the market, the other is moving the same amount, but in the opposite direction. This is known as a perfect hedge, or a market-neutral portfolio. In the real world, each company has non-systematic, or company-specific risk, which is the risk that theoretically, you can get rid of by diversifying, that is, owning a large enough number of stocks so that the company-specific risk is balanced out to zero. you cannot get rid of systematic (also known as market risk) with diversification, but you can by hedging (owning long and short positions within the same portfolio, or by using dirivatives (options and the like). We will not discuss dirivatives here.

A perfect hedge would normally be used by a manager who is only interested in exploiting the differences between two or more companies, only relative to each other, with no outside influence by the broader market.

For example, let’s say a manager thought that Dell was a poor company compared to Microsoft. After analyzing both companies, he might feel that Dell was overvalued and Microsoft was undervalued, given his opinion that Microsoft was a better company than Dell. In this case, he might sell an equal dollar amount of Dell short and buy Microsoft long. He is not interested in what the overall market is doing, but rather only in the relative movement of Microsoft versus Dell. As long as Dell performs worse than Microsoft, he will make money, regardless of whether the overall market goes up or down, or stays flat. To see this, let’s assume both stocks start at $20 per share. If both go down, but Dell goes down more, the manager makes a profit. Again, it doesn’t matter if the overall market goes up, down, or sideways.

If there is a huge correction in the stock market, and Dell goes down to $15 but Microsoft only goes down to $17, the manager is still profitable by $2 per share (the difference between the two prices, since both stocks started at $20 per share.) Conversely, let’s say the market rallies and both stocks go up, but Microsoft, being the better of the two companies in this hypothetical example, goes up more than Dell, moving up to $25, but Dell only goes to $22.

The manager again profits by the difference between the two ($3 per share), regardless of what the overall market has done. The manager can always be wrong with his analysis, so the market-neutral hedge approach is not a guarantee of profits, but if the manager loses, it will not be because of what the overall market does, but rather because Dell performs better than Microsoft in our example, making the difference between the two stocks negative (a loss) for the manager. (If they both go up, but Dell goes up by more than Microsoft, the manager loses. If they both go down, but Dell goes down by less than Microsoft, the manager loses.)

Another method of hedging would be to use options, futures, or short positions in ETFs (exchange traded funds) to protect portfolios from downside risk in the event of a correction or bear market phase. This can be a particularly effective strategy for investors with high tax brackets and large unrealized gains in their portfolio. The hedge helps to protect the portfolio from losing value in downward cycles without selling existing long positions, and thereby realizing capital gains.

What we offer through The AWM Long-Short Equities Strategy, is not a market-neutral, perfect hedge strategy. Therefore, the direction and magnitude of overall market movements does affect performance. In fact, we are making investment decisions based directly on the direction we believe the overall market will take, and also on our expectations for the direction of specific sectors of the economy, industry groups within those sectors, and individual companies within those industry groups.

By focusing long positions in areas of the market we believe to be undervalued, and short positions in those areas we believe to be overvalued, we believe we can increase returns, while still keeping overall risk (portfolio volatility) lower than with a long-only strategy.

The AWM Long-Short Equities Strategy is a very popular strategy with clients because it offers the benefits of the investment performance potential of a hedge fund approach without all of the pitfalls of hedge funds.

Those pitfalls include: Lack of Transparency – in a hedge fund, clients do not receive regular statements showing positions owned, etc, so clients must trust that the fund manager is doing what they say they are going to do. Unfortunately, as we have seen with the recent explosion of hedge fund debacles, this is sadly not always the case (Amaranth lost over $5 billion in one week, even though they sold the fund as a low risk hedge fund, etc.) High Fees – hedge funds charge a fee of 1% – 3% plus typically 20% of profits.

Fees for The AWM Long-Short Equities Strategy consist of the asset-based fee with no additional performance-based fees. High Watermark – hedge funds use a high watermark, which is simply the way in which they calculate their fees based on the value of assets managed. Example: Let’s say you start with 100% and in the first year a hedge fund generates profits of 20%, so that your investment in the fund grows to 120%. The fund would charge you 20% of the 20% profit, which would be 4% (.2 X .2 = .04), and your high watermark is now 120%.

Let’s say that in year two, the fund performs poorly, and that the value of your investment drops to 90% of your original 100% investment. Now the fund manager has a dilemma – they will only earn 20% of any profits they generate for you if they can grow the fund to a level above the high watermark of 120% of your original investment, which means they have to make your 90% grow by 33% (30%/90%) to get your investment back to the 120% high watermark BEFORE they will earn any additional fees other than the 1% – 3% flat fee they charge. The fund manager’s incentive to make you money is drastically reduced. He or she is much better off going out and finding new investors so that he does not have the gap between current value and the high watermark. (Hedge funds are structured as a fund, meaning that all money is pooled together into one portfolio, so technically speaking, all investors in that specific investment vehicle are treated the same (another pitfall – no customization for each client), but there is nothing stopping thea hedge fund manager from starting a new fund, which would allow him or her to start with a fresh high watermark.)

An additional problem associated with the high watermark, and with the way hedge funds charge the 20% of profits fee, is that many investors access hedge funds through brokerage firms or other advisors. If we look at the previous example where the hedge fund did well the first year and poorly the second, the broker or advisor may recommend changing hedge fund managers. If you take your 90% that is the value of your investment after year two, and invest that amount with a new hedge fund manager, that 90% becomes his beginning high watermark, meaning that any profits he makes above the 90%, he gets to charge you the 20% of profits fee.

Now you are paying fees on “profits” even though your investment is below what you started with in the first hedge fund (90% versus the 100% you originally invested). Unless and until the second hedge fund manager can grow your investment to a level above the 120%, which was your high watermark with the first manager, you will be paying the 20% of “profits” fees on profits that you already paid the fees on previously, and on any amount between your current portfolio value (90% in this example) and your original investment amount (100% in this example). Restricted Liquidity – Hedge funds restrict withdrawals, typically to one day a quarter, and can also deny withdrawal requests if they are experiencing large losses, or large withdrawal requests, meaning that at the time when an investor would most want to get out, when the fund is performing poorly or experiencing severe financial problems, the fund can deny their request. In the case of Amaranth, this is exactly what happened, and investors lost virtually everything they had invested, receiving only pennies on the dollar.

Since AWM has full transparency, offers very reasonable fees, uses separate accounts for each portfolio managed, offers full liquidity, and does not charge the additional 20% of profits fee, clients get the benefits of a traditional hedge fund strategy without the pitfalls of hedge funds.

For more information about The AWM Long-Short Equities Strategy, please call 805.898.1400, or email us at: craig@craigdallen.com

FEE SCHEDULE The AWM Long-Short Equities Strategy Brochure (.pdf)
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