For the past 20 years, managing a short-bias or short-only hedge fund has been a little like one of the stunts performed by street magician and certified masochist David Blaine. Like Blaine, short-only fund managers have voluntarily put themselves in highly uncomfortable, cramped, painful situations in pursuit of their mysterious craft. The chart below showing the track record of the CS/Tremont Dedicated Short Index illustrates how the short-only crowd has endured the equivalent of being submerged in a tank of water, enclosed in a giant ice cube, suspended in a glass box, and forced to stand on a 75 ft. poll for a day and a half. And still, they soldier on.
As passers-by gawk at the spectacle, some have marveled at the display of resilience and determination while others have scoffed at these managers – as they often do at Blaine – saying things like, “What a loser. Why doesn’t he get a real job!”. But everyone wonders what could possibly motivate such apparently irrational behavior.
Aside from those who await the arrival of a much-anticipated alien invasion and subsequent collapse of society, many short-bias managers are in the game for the right reason: alpha. In fact, some research has shown that while short-bias funds fight a constant uphill battle, they are actually quite adept at producing alpha (see related posting). In other words, they lose less than one would expect them to lose (like Blaine only falling into a coma, rather than dying during one of his stunts – a stunning success!). Therefore, if these funds are hedged by, say, a long S&P 500 position, then they could theoretically add a lot of value.
While most investors acknowledge this theoretical reality, many investors’ quest for “absolute returns” means short-biased funds are generally used only as (short term) outright calls against the market.
Now one firm has come to the rescue of the much maligned short-bias manager and has developed a compensation framework that rewards alpha, not simply absolute returns. While absolute return investors might bristle at the possibility of paying a manager a bonus for simply losing less than the market, such a compensation scheme could just as easily mean lower fees when a short-only manager unwittingly benefits from a bear market.
The firm is US-based institutional manager Tuckerbrook Alternative Investments. According to the firm’s managing director, John Hassett:
“Short managers have never been paid for what they have been hired to do. They have been paid for return, when they have really been hired to mitigate beta, break the back of correlation, and reduce the volatility of a long portfolio they are generally not even allowed to see.”
It’s no wonder some high profile short managers have signed up. According to the firm’s press release, six managers have signed on to this “patent-pending” structure:
“The new, patent-pending structure compels the production of simple alpha (out-performance over the inverse of a like benchmark) but rewards the managers for such alpha, based on exposure management acuity. The formula calculates simple alpha at the end of a year, but the percentage of such alpha the managers earn in performance fees is based on a sliding scale related to capture ratio. That is, if the short portfolio produces alpha in a given year, the performance fee earned on that alpha ranges from 5% to 40% depending on when the alpha was produced. If, in down markets the short portfolio made more than the market lost, while in up markets the short portfolio lost less then the market gained, the fee is higher.”
With many long/short managers bailing out of individual short positions in favour of short ETF positions or short index futures (see related posting), this unique brand of “short alpha” may turn out to be a popular commodity going forward. But even if markets don’t tank and the aliens get distracted for a while, this group of managers is convinced that short-only funds have an important role to play in portfolio construction and ongoing risk management. And now that they can actually get paid for delivering these benefits, many short managers who gave up their craft and went long/short (or long-only) in the 1990s might be wooed back into this odd combination of alpha magic and death-defying feats of investing.