Bad News: The market currently offers hedge fund equity exposures that are expensive, tax-inefficient, opaque, and the underlying process is often questionable.
Good News: We outline a Do-It-Yourself (DIY) hedge fund equity solution, that is affordable, tax-efficient, fully transparent, and backed by empirical evidence.
The Quest to Find a Tax-Efficient Hedge Fund: How this all got started...
Over the past few years, we were asked--on multiple occasions--to create long/short strategies that leverage our quantitative value philosophy.
The business of providing long/short products is great: management fees are higher and third-party marketing folks love to sell this stuff.
But there were two problems:
- We believe in evidence-based investing, not story-based investing.
- We also believe in delivering affordable active management, not expensive active management.
The other problem we needed to solve was how to actually run the long/short system.
Having studied hundreds of systematic value-investing strategies at this stage, our conclusion has always been the same: long/short investing is difficult...especially on the short side!
Our conclusion--based on the evidence--is that shorting stocks, after considering the true costs--fees, taxes, operational risks, complexity risks, and so forth--is simply a sucker's game.
Based on the evidence, we told investors desiring a long/short solution that a Do-It-Yourself long/short equity approach is favorable. A DIY investor simply takes a long-exposure they believe in and uses an appropriate index future to hedge out market risk (e.g., S&P 500). For a zero-percent management fee (DIY has its advantages), an investor can create a long/short equity hedge fund for the same cost as a long-only investment strategy.
We've done the research on other long/short value strategies in the marketplace, here and here, but to date, we have never described what we consider to be a reasonable solution. In the analysis that follows we build a long/short system using our quantitative value strategy as an example. However, an investor can leverage
Quantitative Value Absolute Return--Enters the Race
The Quantitative Value Absolute Return (QVAR) solution is an affordable, tax-efficient, transparent, absolute return strategy.
As our readers know, we believe in transparency, not black-boxes. As such, here are the details on our strategy:
- Buy the cheapest, highest quality value stocks. We do so by following the 5-step process outlined in our Quantitative Value philosophy.
- Identify Investable Universe: Our universe generally consists of mid- to large-capitalization U.S. exchange-traded stocks.
- Forensic Accounting Screens: We conduct financial statement analysis with statistical models to avoid firms at risk for financial distress or financial statement manipulation.
- Valuation Screens: We screen for stocks with low enterprise values relative to operating earnings.
- Quality Screens: We rank the cheapest stocks on their long-term business fundamentals and current financial strength.
- Investment with Conviction: We seek to invest in a concentrated portfolio of the cheapest, highest quality value stocks.
- Dynamically hedge market risk with an S&P 500 futures contract.
Different investors have different risk/reward preferences, so we have created 3 options, described in the figure below:
For each of the three solutions, the long portfolio consists of stocks that rank the highest on our Quantitative Value (QV) algorithm. For the QVAR Aggressive and the QVAR Moderate strategies, the QV exposure uses leverage to attain either a 150% or 125% long exposure. One could also use high-conviction value investing etfs or value investing funds offered in the marketplace.
How Does QVAR Work?
A detailed example helps elaborate how the QVAR process works. Consider the QVAR Aggressive strategy: We would invest $1.50 into our value portfolio, and short a notional value of $0.50 via an S&P 500 futures contract (the "hedge"). In addition to the constant $0.50 hedge, there is a dynamic aspect, which could add an additional $1.00 hedge, or a total of $1.50 notional market hedge against a $1.50 long book.
How do we determine the dynamic hedge? We use a combination of momentum and moving average rules (explained here) to time our dynamic market exposures. In the QVAR Aggressive case, the dynamic hedge component can either be $0.00, $0.50, or $1.00. Thus, the net market exposure for QVAR AGG can range from 100% (if the dynamic hedge is $0.00) to 0% (if the dynamic hedge is $1.00). Similarly, the QVAR Moderate strategy net exposure can range from 75% to 0%, and the QVAR Balance strategy net exposure can range from 50% to 0%. Note that when the net exposure is 0%, you are taking a long/short bet on the performance of the Quantitative Value strategy relative to the S&P 500.
The Short Portfolio
A quick note on the short portfolio. Many people believe that you should short "expensive" stocks. As value investors, we want to believe this story more than anybody. But evidence matters and shorting individual expensive stocks isn't the best solution. We punt on trying to short individual securities, and instead use an S&P 500 future. While this sounds too simple, the empirical evidence supports this approach and this approach is much cheaper on an after-cost, after-tax basis for a taxable investor. First, on the cost front, futures are much cheaper to short than a basket of individual securities, which have rebate costs, transaction costs, and carry serious operational risks. Futures are not free, obviously, as they have embedded funding costs, but these rates are set by institutional investors and are much cheaper than those charged by retail--or even institutional--brokers. There are also transaction costs, but these are counted in single-digit basis points (e.g., 3-5bps). Second, and most importantly, futures are 1256 contracts, and any gain or loss is treated for tax purposes as 40% short-term gain and 60% long-term gain. This is a huge tax edge compared to shorting individual securities, which are always taxed at short-term capital gain rates and often require that investors add short dividends back to their basis and not consider a short dividend as an expense. Again, taxes matter a lot more than alpha!
A bit more on the tax side. Let's set up the hypothetical scenario where the market declines 30%. If we are hedged using an S&P 500 future, we have a "gain" of 30% on the short side. The taxes paid are as follows (30% return)(40% short term)(43.4% top short-term rate + healthcare tax) + (30% return)(60% long term)(23.8% top long-term rate + healthcare tax) = 9.49%, so the after-tax return is 20.51%. Now, let's say we have a great "short stock manager" who beat his benchmark by 5 percentage points. So when the market was down 30%, he picked a portfolio of stocks that was down 35%. Quite the impressive year for this short stock manager.
However, what are the taxes paid?
Since the shorting gains are created by shorting stocks (not using futures) they are taxed at short-term rates. Thus, the taxes paid are as follows (35% return)(100% short term)(43.4% top short-term rate + healthcare tax) = 15.2%, so the after-tax return is 19.8%. On an after-tax basis, you would have been better off hedging with a simple S&P 500 future! We like robust solutions, while also worrying about taxes, which is why we use this simple short strategy.
How Does QVAR Perform Historically?
We went back and tested the QVAR strategy from 1/1/1975 - 12/31/2013, which is the entire data sample period. Results are net of 1.49% management fees, a 1.00% transaction cost, and +/-0.25% funding spread (i.e., margin costs fed funds plus 25bps and short proceeds receive fed funds minus 25bps). For illustrative purposes, we short the S&P 500 Total Return Index and not the S&P 500 futures because of a lack of futures data going back historically to 1975. All returns are total returns and include the reinvestment of distributions (e.g., dividends).
Here are the results:
Again, as an absolute return strategy, not long-only, there are multiple years where the strategy lags the index by a substantial amount:
A quick review of the annual returns highlights the "alternative" nature of QVAR. There are many years where the market is up and QVAR is down. There are also a handful of years where the market is down and QVAR is up. The real goal of QVAR is to be up as much as possible, and minimize large drawdowns. Also important to note is the volatility, which is extremely high, even with a simple short book in the form of a generic market hedge.
The number of complex, optimized, and so-called "proprietary" value long/short strategies are too numerous to list. We've seen just about everything in our role as academics as well as consultants to an enormous family office.
And of course, with fancy Manhattan offices, comes high fees, no transparency, and low liquidity (lockups). You'll also get great stories that are often backed by little to no empirical evidence. As we have shown before, trying to short expensive stocks is not a great idea!
We think a simple solution to an investor's long/short equity woes is to focus on buying the cheapest, highest quality value stocks, and dynamically hedging the market risk with an S&P 500 futures (both the constant and dynamic hedge).
Savvy investors can implement the solution we've proposed: buy a basket of the cheapest, highest quality value stocks and negate market risk with tax-efficient low-cost equity futures.
And if you are simply too overwhelmed by portfolio management, we can implement custom tax-efficient hedge fund replication solutions at costs that are more affordable than the average hedge fund offerings--especially on an AFTER-TAX BASIS!
Please contact us if you are interested.