Long-ShortMedium

3 min read · 602 words

What the seat actually does

A long/short fund owns shares it expects to do well and is short shares it expects to do badly. The point of the second half is not simply to make money when things fall: it is to remove the part of the return that was never the idea. If a fund is long one carmaker and short another, the outcome depends on which is the better company rather than on what the market did that month.

• Gross exposure — longs plus shorts, which is how much is at work.
• Net exposure — longs minus shorts, which is how much market is left.
• A fund can be 150 gross and 20 net: a lot of positions, very little market.

Being short is not the mirror image of being long, and this asymmetry governs the seat. A short position grows as it goes against you, the loss has no ceiling, the shares must be borrowed and can be recalled, and the borrow becomes most expensive exactly when the thesis is most crowded.

A day, and where it goes

• Overnight — anything that moved in a name held, and whether it changes the reason for holding it.
• Exposure — gross, net, and by sector and factor, because a book can be market-neutral and heavily exposed to something else without anybody deciding to be.
• The borrow — what is available, what it costs, and what has become hard to borrow, which is information in itself.
• Research — the work behind the next position, and the work that says an existing one was wrong.

What it is measured on

• Return above cash, not above an index. A fund charging performance fees for market return is charging for beta.
• Alpha after the factors are stripped out — much of what looked like stock picking is a persistent tilt to something cheap, small or volatile.
• Drawdown, and how long recovery took. See the arithmetic of drawdowns.
• The short book on its own. Most long/short funds make money on the long side and lose it on the short side; a short book that pays for itself is the rare thing.

What it touches on this site

• The mechanics of a short — securities lending and margin and collateral.
• What is held — cash equities and total return swaps where the exposure is taken synthetically.
• The other side of the idea — who is on the other side.
• What happens when a short is crowded — 2021, and the leverage behind the swaps.

How it goes wrong

• The squeeze. A crowded short in a small float is a position whose exit is the same trade everybody else has to do.
• Borrow recalled at the worst moment. The lender wants the shares back and the position is closed by somebody else's decision.
• Neutral on paper, not in fact. A book flat to the market can be short quality and long leverage, and find out on a single day.
• Being right too early, which in a levered book is indistinguishable from being wrong.

Concepts to master

• Gross and net answer different questions. Net says how much market; gross says how much can go wrong at once.
• A short's loss is unbounded and its position size grows as it moves against you — the opposite of a long, which shrinks.
• Factor exposure is taken by accident. If it is not measured, it is still there.
• Borrow cost is part of the thesis, not a friction around it. A short at eight per cent to borrow needs to be right quickly.