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The Mechanistic Beauty of 130/30 Long Short Hedging - Secrets of the Hedge Fund Industry

Hedge funds come off as an exotic and mysterious sector accessible only by wealthy inner circle businessmen. Yet given the right quality, the 130/30 hedge fund posture can be right for your individual investing. If you pick stocks at all, the mechanistic beauty of 130/30, based on risk analysis and the cost of capital, is a simple, powerful concept. It’ll change your most precious resources of wealth and time.

Any person accumulating wealth faces the mathematical realities of their situation- it’s simple to estimate future wealth. In a rule of thumb dating back at least 100 years, all investment compounders are subject to the rule of 72. The rule of 72 goes like this: take your return rate, for example 8% yearly return on a diversified market portfolio is reasonable. Divide 72 by the 8% rate, to yield 9 years. It’ll take 9 years to double your investment at the 8% rate. Everyone only has so many 9 years in their lives! Nothing is new about this.

Now we put on our engineering hats. What are the variables that can change? We’re seeking a universal method to increase the rate of return. A simplistic answer is to leverage, that is accept a higher level of risk return via financial arrangement. Leverage is the siren’s call to any financial operation, full of allure and danger. There are at least three ways of leverage available to common investors. 1) We can borrow money, either through a loan at a bank or revolving credit, say through a credit card, 2) we can engage in derivatives which are complex financial instruments that we discuss in the linked video, 3) we can borrow securities against so-called marginable securities as an asset-backed loan and immediately lend them out to another investor, the complex arrangement known simply as short-selling, which is a borrowing and immediate lending.

title Derivatives: Financial WMDs. Used by Warren Buffet and Archegos Capital!

The 130/30 long short portfolio has a long history. Carol Loomis writing for Fortune magazine in 1966 ascribed the technique to Alfred Jones, a PhD sociologist. Warren Buffett goes on to contradict Loomis, ascribing securities borrowing to his mentor Ben Graham in the 1930’s. Buffett himself approached commercial banks early on to borrow securities. Allegedly, the story went that they asked him which stocks he wanted to borrow. He answered, “why any that you would be willing to lend me”, which only deepens the present riddle we untie. Why is the 130/30 long borrow posture so mechanistically perfect?

As Jones originally called it “speculative techniques for conservative ends”, the hedged nature is key. 130/30 uses leverage specifically in a hedged posture. When borrowing 30% of securities to buy 30% more securities, the expected equity exposure would be an additional 60% from 30+30. Instead, the exposure is more nearly 0%. The reason being the short 30% and the long 30% are hedged, their market risk most nearly offsets each other. Thereby we expect in excess of the market return while exposing only to the base unity amount of risk. This is why Buffett was willing to short even a presumably random sample of securities. The beauty continues.

We expect that leverage is more safely employed when it’s structurally hedged. The next piece is that the cost of borrowing securities is exceptionally low, leading to a fantastic cost of capital. Known as the borrow rate, for liquid large companies, the rate is usually on the order of 1%. The borrow rate is a floating rate that fluctuates with supply and demand. If there are fewer owners of the security willing to lend it out, the owners are able to charge a higher price. Because of elastic supply and demand relation, borrowing securities should be performed carefully, namely always with stop loss limits determined in advance of entering and revisable only to tighter limits. Further, triggering stop loss on the borrow side must translate to a bracket order on the long side to rein in the leveraged exposure. Another point is that by borrowing the security and lending it out, you are on the hook for the dividends paid out by the security too. Nonetheless, such provision is vastly superior than the margin rate on cash, which as the fed cranks rates, is at latest reckoning over 5% and rising.

So once the 130/30 structure is in place, we can use the framework of alpha, the active management contribution to return. If a manager is able to deliver 1% of alpha on a portfolio, our previous example would net 8%+1% equaling 9% of total return. With the 130/30 exposure in place, now the return could rough out to 160%, meaning 14.4%. If we use the rule of 72, we expect doubling our investment every 5 years instead of 9 years. We’ve saved 4 years of time in the compounding world at a better risk trade-off than margining cash. Note, a more conservative calculation is 1.6x alpha only, for 8%+1.6%, giving 9.6% expected return, doubling 7.5 years. The lower bound would then be saving 1.5 years.

Well that sounds fantastic, but what are some caveats to mention as an abundance of caution. Buffett and Charlie Munger mention at least one, whinging about promoters who would pump up the price of a security for no reason connected to intrinsic value. This is a practical concern and constrains the concentration of borrowed positions. Even more drastic, there’s the discrete nature of markets that can gap prices, say via private market acquisitions, taking private, or long-tailed behavior covered in our video on Financial Weapons of Mass Destruction. Yet another reason to preclude concentration. Already one solution comes to us from Buffett, by borrowing against a diversified basket of securities, a market ETF, we can eliminate some of the granular borrow side risk at the cost of the alpha on the borrow side. Perhaps a small price to pay to bend the arc of time safely.

Then there’s the question of why not a higher ratio, say 140/40 or 150/50. The level has to do with the lending requirements on net asset value. Holding to 30% borrow against NAV means the account will be far away from a margin call. Generally only if the marketable value of the long positions fell by 70% would the account expect a margin call. No one likes margin calls.

Now circling around, there’s another reason not to use leverage. If there’s no expected alpha, then there’s no point in the long borrow posture. The simple example is borrowing a whole market basket to buy a whole market basket is the equivalent of 1 plus negative 1 equals 0, and in this case a little worse since there’s the 1% borrow cost and transaction fees. If you are picking stocks, then that means you are expecting a positive alpha.

Finally, not all brokers allow borrowing securities. Even more sadistic, some brokers promote leverage via options, with cost of capital easily ranging above 30% (yes greater than 30 times our 1%), not to mention brokers selling order flow. We won’t recommend any brokers here as we’re sure there’s a competitive market out there for users to discover.

Now a few loose ends. According to Buffett and Munger, Buffett doesn’t use 130/30. Some of the reason is once in the upper echelons of capitalism, it’s not exactly sporting to borrow huge chunks of other companies stock. There’s other elements that limit large capacity centered around market impact when choosing borrow targets, which we won’t cover.

With that, we convey an overview of the mechanistic beauty of a 130/30 posture. It’s structurally hedged, has a low cost of capital, and is readily accessible to most investors. It does mean additional complexity, and the fact remains 90% of active managers underperform the market. Leverage never helps the underperforming manager and causes the red marks on hedge fund performance that Buffett loves to bandy about. There’s probably one simple way to determine if a manager is in the 10% or the 90% and it’s definitely not just track record. In any case, the mystery of the private fund world is drawn away from a practical perspective, revealing some quirks. If there’s enough interest, we can discuss why the largest private equity funds DO NOT use 130/30.

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In the research process, we interviewed several finance academics and professionals, people who have graduate work to even a PhD in finance, and they couldn’t describe fully the 130/30 benefit. And we even saw figures like Carol Loomis who have a partial picture. Buffett undoubtedly has the whole picture. As someone who came from the ivory tower, this shows the limits of academic training and this writeup is dedicated to former peers for their better investing. For our academic friends, we do link a paper covering back testing results on 130/30 vs long portfolios.

1 The Performance of the 130/30 Strategy in the Australian Equities Market