Thursday, March 27, 2008

The best strategy for profitable trading in any market

It's basically the "old style" hedge fund strategy, and many modern day hedge funds follow the equity long short or "equity hedge" strategy. But don’t let the name fool you… even though this strategy plays both long and short sides it should not by any means be considered neutral. This is a market directional strategy that requires two distinct portfolios: one consisting of long stock positions and the other short positions.
But it typically produces significant market exposure by being overall net long. But in practice it's simple: you go long what is rising in price and go short what is declining in price....For example, if a manager were following this strategy, he would hold a portfolio that consisted of being long a group of individual growth stocks and short S&P futures, or a group of individual stocks he expected to decline.
The key is that there is more long exposure than short, so on net the portfolio as a whole is long. It is important to keep in mind that the amount or degree of this net long exposure varies depending on market conditions. In a strong trending bull market the short side of the portfolio would be minimized, increasing net long exposure. When prices are going down the amount of short positions would increase, dramatically decreasing net long exposure (while still remaining long on net). The benefit of this strategy lies in the ability to generate return from both the long and short side. Even though this strategy combines long and short positions it does produce systematic risk, meaning that it is affected by the direction of the market.

There are two methods to following the equity hedge strategy. They are the fundamental equity hedge strategy and the quantitative equity hedge strategy. The fundamental equity hedge strategy is driven from the bottom up, as individual stocks comprise the portfolio. Thus, competence with stock-picking and individual company analysis is a key skill in making this strategy a success. This is a viable strategy for many individual investors that manage their own money and enjoy doing research and analysis on individual companies, especially those who have an expertise in a certain market sector or market segment.

To implement this strategy, a manager could simply go long stocks in a hot sector and short stocks in a poorly performing sector and generate good returns. Clearly, the level of risk depends on the specific positions of the portfolio and the degree to which the portfolio is long on net.

But in general, do not be fooled by the level of risk exposure that can be generated by the equity hedge strategy. It can in fact entail significant risk. Traditional portfolio risk measures such as Beta rely on an assumption of a broadly diversified portfolio and thus can not accurately measure risk for portfolio strategies such as equity hedge due to the concentration in certain positions.

Unlike the fundamental strategy, the quantitative equity hedge strategy involves statistical arbitrage between a wide variety of markets. The kind of complex statistical arbitrage employed by large institutions and hedge funds is beyond what any individual investor would want to be concerned with. However, the concepts of the fundamental hedge strategy can certainly be understood and applied by most investors. It is a strategy that relies on the investors analytical skill in picking individual stocks, and market segments.

The equity hedge strategy depends heavily on manager skill and the ability to pick individual stocks that will increase in price as well as the ability to find stocks that are in trouble and declining in price. If you have this skill and the ability to successfully judge the correct amount of exposure in light of overall market conditions then this strategy may be right for you.
There is always an interplay between the broader market conditions and an individual stock and there are many ways to combine an investment style with a particular strategy such as this. As an example, you could go long stocks that fit the Ben Graham value investing approach while shorting overpriced stocks that are falling. Be careful though, because momentum can take an overpriced pig much farther than anyone can justify, or keep a quality stock in decline for extended periods. --John Bardacino

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