I wrote this article on my old blog in 2009. Although the hedge fund index numbers are a bit outdated now, the main ideas are still valid.
The Almost Zero Difference Between Long and Short
Dollars or euros are the same, regardless of being made or lost with the market going up or down. But in minds of most people – even when we consciously try to avoid it – trading on long and short side still feels different.
Some people are permanent bulls. Though they are still speculators and traders in the very basic meaning of the words, most such people call themselves investors.
Broadly accepted speculating wisdom is that you should try to have as many factors aligned in your favour as possible to improve your odds. Permanent bulls have one of the biggest factors on their side: the long-term economic growth. While not guaranteed for the future (nothing is), it has been well tested and has been around for thousands of years (when you look at time periods long enough).
Long Term Profits with Short Term Pain
If they diversify and manage to avoid big mistakes, permanent bulls make money over the long run. Beating inflation is a bit more difficult, but it still can be done without a sharp edge. Just once in a while permanent bulls get really depressed when stock market drops. Those who sustain their bad feelings and are diversified enough make the losses back sooner or later. No pain no gain.
The downside of being a permanent bull is that your performance is largely at mercy of overall market direction and in a time period shorter than long chance is that you would not like the performance, nor you would like the volatility. Look at S&P500 in the last 10 years.
Some people are permanent bears. You can invest in funds that focus on short positions only or continuously maintain net short market exposure. Many of them have the words bear or short in their names. Hedge fund index providers like Credit Suisse Tremont or HFR measure the whole category of funds called Dedicated Short or Short Bias funds.
Besides hedge funds you can invest in bearish ETFs. Or you can take bearish positions directly. With the boom of online brokers and derivatives (and the 2008 market turbulence), the popularity of taking speculative bearish positions has grown rapidly. Today you can easily short stock index futures with negligible transaction costs and enormous leverage even on small retail accounts.
The Downside of Being a Bear
Unlike the bulls, bears can’t hide behind the long-term economic growth. Conversely, they are exactly on the opposite side. Without skills and hard work it is impossible to sustain good performance with a purely bearish strategy in the long run. Diversification doesn’t help here much.
According to hedge fund indices, dedicated short funds as a group represent one of the weakest hedge fund styles in terms of long-term performance, even after including 2008. At its recent peak in February 2009 Credit Suisse Tremont Hedge Fund Dedicated Short Bias Index was still losing money (-4.8%) in the period since the end of 1993 (the inception of Tremont indices), while all the other styles were in the range between +69% (fixed income arbitrage) and +498% (global macro). Given the stock market rally and relative normalization of conditions since March, all hedge fund styles recorded gains since then, except for managed futures (-3.5% from February to September 2009) and dedicated short (-28.0%).
While exclusive short selling can be hugely profitable in times of market slump, it tends to lead to gradual but persistent losses in times of market boom or sideways movement.
Sometimes Bull, Sometimes Bear
Besides permanent bulls and permanent bears, there are funds and traders applying a mixture of both. Their methods and trading vehicles vary and so does their performance. Some hold long and short positions at the same time and try to profit from changes in price differences between more or less related securities. Others try to time the overall market direction and quickly switch from bullish to bearish positions and back. Some study individual companies, while others focus on broad macroeconomic trends. Others don’t care about the fundamentals at all and base their decisions solely on technical analysis or complicated quantitative models.
What is Your Goal?
The group of bear-bull strategies is very diverse. So is their behaviour under different market conditions and the risks they represent. Understanding them will make it easier for you to choose which ones suit you, based on your performance goals, capital, and time budget.
While some people just want a relatively safe way to invest their savings and a return of several percent a year, other people prefer being more active part-time or even full-time traders. Where are you?
Though there are websites which promise million dollar profits working “a couple of minutes a day” applying their secret black-box trading systems, the truth is that the better performance you want to achieve (more percent, more dollars), the more time, knowledge, and effort you must put in and the more risk you must take. There is no way around this rule. Of course anybody may luckily make a big profit, but without a sound trading strategy and risk management, such gains can’t be sustained over the long run.