Two Sides of a Short Position - A High Quality Argument on Netflix

During my time as an analyst of hedge funds in 2000-2002, and later as a consultant working on portfolio management and risk management issues with hedge fund portfolio managers, I have been granted the privilege to hear the fundamental cases for positions taken by very good managers. Hearing about a single position in detail gives a potential investor or investment advisor some insight into how managers think about their positions. When consulting I would always ask how typical the sort of position is, as there is no structural insight given in hearing about something that is outside the usual style for the manager.

I look for several key points during discussion – how did the idea arise; what made the manager devote the scarce resource of research time to the company/industry; did the manager procure or carry out primary research on the company; at what level of the company has the hedge fund manager met management and how often; what sort of catalysts does the PM like to see, and has the hedge fund manager identified a catalyst for a change in fundamentals or for a change in (stock) market perceptions? All of these points will enable an outsider to gauge whether there is an edge in research. Consideration of the edge (if there is one), along with the breadth and depth of human resources in analysis, and a view on the creativity/fertility of the manager's mind, will feed into an assessment of the quality of the manager's alpha source and the potential for consistency in the alpha stream.

So it is I read with interest the published debate about Netflix between Whitney Tilson, the value-oriented founder and Managing Partner of T2 Partners LLC (www.T2PartnersLLC.com), and Reed Hastings, CEO of Netflix Inc. You can find Tilson's full rationale for his short position in Netflix at http://seekingalpha.com/article/242320-whitney-tilson-why-we-re-short-netflix, and the response by the Netflix CEO at http://seekingalpha.com/article/242653-netflix-ceo-reed-hastings-responds-to-whitney-tilson-cover-your-short-position-now. Most unusually for such a dialogue, it is a very high quality argument.

In this case the Netflix short is smaller than any of the top ten longs in the T2 portfolio. The fund manager does not have to be right on any one position, but how he (or she) deals with being right/or wrong in money management terms is important.

Information Edge Five - Speed & Selectivity

Last year I wrote four times* on hedge funds utilising an information edge. The edge has to be exploitable and and through repetition become significant to the return series of the fund. This applies whether it is an edge in understanding (say the ability to extrapolate from few data points or read across from related industries) or more pertinently an edge in receiving proprietary information not generally available. There can also be an edge in hedge funds in the speed of reciept of information.


This last (superficially unlikely) edge is exploited by high frequency trading algorithms and stat arb managers. The extreme case of this need for speed is evident in the clustering of server farms near the exchanges. There can be a milli-second advantage of signals being received and sent over short physical distances between the computers generating trades and the exchanges fulfilling the orders down the pipes, whether on dark pools or electronic books on the bourses.  These systems are blind with no emotional or subjective inputs, but rely on accurate, logical and continuous pricing. As such, automatically traded capital is subject to event risk - if you like, the news on companies and sectors can get in the way of treating shares as trading chips for playing with minute-by-minute. 


This topic came to mind in reading a press release from Selerity, which describes itself as a low latency, real-time fact aggregation and event data company that caters to sophisticated investment firms including hedge funds, banks and proprietary trading firms. The Selerity technology searches and extracts "event data" from real-time primary sources, and delivers to clients machine-readable, actionable input.


In a new development Selerity software can now work with earnings pre-announcement event data as part of its content offerings to allow traders to use or avoid unexpected, market-moving events in their trading strategies. Corporate preannouncements are real-time, breaking updates released by companies regarding changes in their outlook or guidance ahead of scheduled earnings announcements, and as they are unscheduled fundamenal inputs these announcements can be disruptive to cluster trading, pairs trading and other high frequency trading strategies.


One of the essential tasks managers of high-frequency trading strategies (and nearly all quant managers) is to define their universe to exclude the outliers, anomalous stocks - those subject to corporate activity, and those having scheduled news releases for example - and make an effort to leave in their programmes only suitably qualified stocks by their criteria. Promptly identifying stocks that are subject to unexpected changes in earnings guidance from company management would help algorithmic traders and traders who deal in whole portfolios from being left marooned with unintended idisyncratic risk in the holdings/portfolios. 

There are many hedge funds that engage in event-driven strategies. The larger and more sophisticated ones use software systems to trawl through court documents, SEC Filings and other lengthy documents to find the few nuggets of information they seek. It is the document equivalent of conference delegates that come away with two or three quality pieces of insight or new understanding from a whole day sitting listening to presentations. The more deep and diverse the information inputs a manager uses in their process the more applicable are these tools.

The Selerity product is a specific example of a delivering appropriately framed and focussed information on a timely basis to a hedge fund or  investor of risk capital. But nearly all hedge fund managers need information of that sort, whether it is delivered via human vectors or software crawlers and spiders. The information edge has to supported and developed, and have a thorough process behind it.


* http://simonkerrhfblog.blogspot.com/2009/12/creative-way-to-build-hedge-fund-brand.html
http://simonkerrhfblog.blogspot.com/2009/12/information-flows-to-hedge-funds-2.html
http://simonkerrhfblog.blogspot.com/2009/12/podcast-2-discussion-with-uk-equity.html
http://simonkerrhfblog.blogspot.com/2009/11/galleon-edge-illegal-but-information.html

A Creative Way to Build a Hedge Fund Brand Name – Broadwalk Asset Management

I was listening to trader trainer Michael Martin interview Jim Rogers on his excellent website (http://martinkronicle.com/), and I heard Jimmy Rogers say that investors should stay with what they know and are interested in. In working with portfolio managers I often ask them which sectors or types of stock they are good at investing in, and which they can't seem to get right. It may be they can't read retailers, or always seem to mis-time growth stocks, but it is very important to eliminate what you are not good at as a trader or investor. I think of it as playing defence to some extent – by eliminating a repeated error, and focussing on what you are provenly good at your returns have to improve.

There may be an element of ego involved – it may seem a sign of weakness on the part of a money manager to leave out a sector or type of stock from their universe. But investors, and ultimately the manager, will only be interested in the scale of returns achieved. So my conviction is to put the ego to one side, check the data, and eliminate areas of weakness. For example I worked with a manager who occasionally dabbled in the financial sector, but whose major strength was in consumer-related sectors. Analysis showed that the hit rate (percentage winning trades) was a lot lower in financial stocks than in other sectors, and I advised leaving the financials alone. Losses in the financial positions were slightly larger than those typically tolerated. If anything the stop-losses should have been tighter and positions sized smaller initially.

The ultimate specialism is sector funds, a strategy area I hope to return to shortly in more detail. In Europe we have begun to be used to hedge funds specialising in sectors, though they are a well established and successful phenomenon of the US hedge fund industry. Investor interest in sector hedge funds should be strong – the return data suggests they can offer enhanced return and lower correlation with markets if the funds have an appropriate framework for portfolio structure. The evidence for this contention is stronger at the manager level than at the index level - there is scope to add a lot of value to a portfolio hedge funds through manager selection in sector funds.

I came across an unusual sector fund this month. The Broadwalk Select Services Fund, run by Charlie Cottam, is Europe's first "Services" sector focused fund. The Fund has been going since June last year, and it has been going rather well. Most hedge funds made money in the first half of 2008 and lost more than their first half gains in the second half of the year. The Broadwalk Select Services Fund was up 1.3% over the last seven months of 2008 through putting in four down months and three up months. Obviously the average up-month in 2008 was bigger than the average down-month!

Charlie Cottam preserved capital well in the first few months of this year, and did better thereafter: through the end of November the Fund is up 44% for the year. The relevant market index for the fund is the FT-All Share Index (the Fund concentrates on UK companies), and that benchmark was down in four months of 2009, and the Fund managed by Broadwalk Asset Management was down in only one of those months. Over the whole life of the Fund the FT-All share has been down 14.6%. According to the manager he didn't get properly invested until February/March of this year, but once he did he made excellent returns through stock selection – the net is now about 80%, and the fund is concentrated (large position size).

The manager of the Fund claims two forms of competitive edge: better information and original analysis. The original analysis comes from Cottam's experience on the sell-side. As a chartered accountant himself he sees accounting issues not well understood by those analysing the service sector specifically. He may have a point as there are few sell-side analysts in the sector with similar tenure as an analyst. The manager himself sees an advantage in his ability to use his been-through-the-cycle experience to turn around his conception on a company and stock quickly – he can grab an emerging opportunity at the time when other analysts are getting out their apocryphal pen to write a research note.

Cottam is an experienced sell-side analyst, and in that may be a true edge as he was company broker to 33 UK corporates. This unique arrangement for UK quoted companies – a corporate brokership for each quoted company – gives the appointed broker a privileged position in terms of access to management. Cottam has kept his company network intact as he has moved to the buy side. His management contacts and experience of individual management teams based on their historic behavior helps Cottam to spot the early warning signs of change in outlook for companies and sectors. His sell side experience enables him to understand the flow information on stocks and their relative positioning in the market.

So Charlie Cottam uses his deep experience in service companies to extract alpha – staying with what he knows and is interested in. He has also taken steps to reinforce his edge by keeping senior management engaged with Broadwalk – last year he initiated the Broadwalk Business Services Awards. This is the second year of the Broadwalk Business Services awards to recognise outstanding achievements by quoted companies in the business services sectors. The UK often leads the world in business services -it is one of the less well-known success stories of the economy, and these awards are a step towards raising its profile. The categories and 2009 winners are: Company of the year (Aggreko), CEO of the year (Nick Buckles, G4S), Chairman of the year (John Peace, Experian), Deal of the year (Balfour Beatty - Parsons Brinkerhoff), Small company of the year (Hargreaves Services), and Entrepreneur of the year (Michael O'Leary, Ryanair).

I think this is a terrific example of creative thinking by a hedge fund manager, and Charlie Cottam's entrepreneurialism and unusual means of brand building are to be commended.

Information Flows to Hedge Funds 2 - Twitter

The best article on information searching for hedge funds that I know about was by Colin Maclean of Scottish Value Management. You can find it on "The Hedge Fund Journal" website at this link.

The search for an information edge goes on. Any source will do. The newswires carried this story recently:

"Traders are using software developed by US-based technology StreamBase to monitor "tweets" for price sensitive information.

The software plugs into Algorithm-based automated trading platforms that have been used by traders for years. But rather than searching Reuters or Bloomberg the software now scans Twitter.com.

Streambase - whose client base includes Royal Bank of Canada and London-based hedge fund BlueCrest Capital Management - was commissioned to develop the software by several "unnamed" clients."

Podcast 2- A Discussion with UK Equity Portfolio Manager Nick Shenton at Polar Capital

Click on the links to download or play the sound files (embedded player available).

Part 1 (7 minutes 51 seconds)

0.30 Joining Phil Hardy at Polar Capital

1.50 Idea generation

4.40 What Phil Hardy brings to the process of stock selection

5.15 Harder to find shorts now

6.30 Shorts can work faster than longs

Part 2 (10 minutes 50 seconds)

0.25 Websites look at daily

1.35 Websites useful for company insight

2.58 Segro as an example

4.50 Recent investment book reading- Niall Ferguson, "The Greatest Trade Ever"

8.37 Risk/Reward for UK equity trades

9.05 Two other influential books - "Soros on Soros" and "Inside the House of Money"

With thanks to Nick Shenton CFA who works on UK equity hedge fund and absolute return products with Polar Capital Director Philip Hardy

The Greatest Trade Ever

By Gregory Zuckerman
Reviewed by Alexandra Scaggs from www.smartmoney.com

Ever wonder how a single trade can create a legend? Gregory Zuckerman outlines how just such a thing happened with John Paulson and the rest of the characters who profited wildly from the collapse of the real estate bubble."

In The Greatest Trade Ever," Zuckerman, who writes The Wall Street Journal’s "Heard on the Street" column, focuses as much on the personalities and characters of the investors as on the bubble and collapse that increased their wealth exponentially.

Players here include Paulson, whom Zuckerman characterizes as a reformed playboy and true skeptic; Paolo Pellegrini, a Wall Street outsider who went to Paulson for his last shot at a career; Jeffrey Greene, the Hollywood version of a big-shot investor; and Andrew Lahde, the young West-Coast investor who cashed out and left finance for good.

The book addresses how deals are made and how personality counts just as much as the financial mechanics behind the trade, which may be why Paulson has come out with a statement saying he is “disappointed” with the book. But Zuckerman shows that in finance, office politics can matter as much as smarts.

Galleon Edge Illegal, But Information Flows to Hedge Funds Can Be Important

The information that hedge fund groups use is a topic that comes into and out of focus. Recently it has been in the spotlight because of the Galleon-related indictments, but it has been a live issue as far back as Ivan Boesky's advanced receipt of deal-flow information in the mid 1980's. Over the years the buy-side has decreased its reliance on traditional sell-side research, partly because of Regulation FD. Also the reliance has been downplayed to put marketing emphasis on the prowess of in-house efforts in research - it is widely marketed as a differentiating factor in asset management pitches. These concepts apply even more so to the hedge fund business.

To a great extent, and particularly in America, hedge fund managers are paid their large fees to be experts in a particular area. As America is home to so many hedge funds and has a deep and broad range of stocks and industries it is natural that there are hedge funds that specialise in particular fields such as healthcare and energy. Investors pay their managers to be the best informed participants in their sector.

This concept applied in different ways to two of the dominant firms of the early to mid 1990s. Michael Steinhardt in his pomp was well known to have the highest commission bill and commission rate on the Street. His thinking was that if he paid the highest rate he would be first call from an analyst or block trader. Given the turnover in his funds and assets under management it is easy to see how he became the biggest client of the brokerage community. And it worked – he was the first call for the sell-side. Steinhardt both traded and invested. So he liked to be in the flow of trading in a stock, and he knew where the axe was in any particular stock. There are many modern era equivalents – if you are a trader-style hedge fund manager you have to have a feel for the flows, and have finely-tuned antennae for the change of ownership in stocks and sectors. This is said to be how some hedge fund operations have grown within the context of institutional investment firms. The transaction flow information from the dealing desks (monitoring institutional and hedge fund flows) feeds the information requirements of the faster-moving hedge fund managers under the same roof.

Steinhardt was an investor as well as a trader. Although he was known for calling the turn in bonds in 1983, he was essentially an analytical investor rather than a macro manager. His background was as an equity analyst, but his trading around long term positions left the impression on the Street that he was what we would think of today as an SAC-style trader. He was not (only or just). Something similar has happened to the perception of what Julian Robertson's Tiger was about. Yes the firm engaged in macro trading, but the core activity was relative value investing within sectors (and in the mature period, markets). The ultimate arbiter was Robertson, but there were analysts dedicated to sectors. Analysts had to defend their views on the sector they covered, and the analysts were expected have profound knowledge of their sectors. In the later stages analysts ran portfolios in their sectors, and so gained the experience that would set them up to become the Tiger cubs that grew out of the firm. But the core competency was depth of knowledge of a sector.

Managers have to have an edge. It is requirement that they are able to answer well the standard question "what is it that makes you unique?" Further, the question had better be answered with reference to repeatable elements. The question becomes "what are you going to be able to continue doing that will give you a persistent edge in your trading/investing in future?" In this regard, it is much less satisfactory to investors to infer that the manager is going to do the same as other people running hedge funds, but do the same things better to deliver superior returns. If the manager happens to be better at using the same information flows as others – better at interpretation or quicker at understanding –that is not as sound a commercial response as declaring possession of an information edge, an unusual source of data. It could well be that money management is the key skill in driving the returns of hedge fund manager. Money management is the change of position size at the stock, sector and market levels. Indeed I have worked closely with a manager who had little edge in information flow, or even in understanding of companies through analysis, but had such good money management and risk understanding that he is an above-median hedge fund manager largely through that ability alone. But money management would not sell as well as a marketing point as an information edge. Rather, investors in hedge funds express strong biases towards managers with information or understanding edges in relation to company fundamentals.

Very often investors will state explicitly that they only invest in fundamentally driven hedge funds. A good example of the latter is the DB Equilibria Japan Fund run by James Pulsford at Deutsche Bank. Using the HOLT system, the approach of Pulsford's team rank return-potential based on RoE, cashflow and other fundamental metrics. Because they match long and short positions in pairs and stay market-neutral they can make good absolute returns using an investing time-frame (multi-month holding period). The DB Equilibria Japan Fund made money last year and this year for its investors. Somehow this sort of investment process is superior in the minds of investors to a manager that uses non-fundamental information to select stocks, or manage the position size.

In my mind the institutionalisation of the hedge fund industry is a factor in this behavioural bias towards fundamentally-driven strategies. They are much more easily explicable, even though there is increasing attention paid to behavioural aspects of finance and investing. And this bias to fundamental styles of investing reinforces the need to demonstrate an information edge. For a manager just using sell-side research it is difficult to claim that they have an edge. Interpretation is not sufficient. So other initiatives have to be taken to have an edge and demonstrate it to potential investors.

The first is the employment of analysts. As hedge fund groups have grown, like the rest of the buy-side they have added analysts. In truth, for investor perception, fundamental analysts have to be added to a small hedge fund operation before any other capability in the firm. Say you are going to add an analyst and you get a nod of the head at an investor meeting. Say you are going to add a marketer to a small hedge fund firm before adding an analyst and the manager would be thought the less of. Not that analysts at hedge fund groups don't add a lot of value in some cases - analysts at hedge funds can be award-winning in their understanding of companies they follow – like Charles Evans Lombe at Egerton Capital in capital goods companies, or Robert Donald at GLG building materials, who both gained plaudits in the Extel survey this year.

The second initiative that hedge fund groups have taken that help them demonstrate an information edge is in procuring (primary) research. Leading hedge funds now deploy a wide range of industry experts on an out-sourced basis via consultancies and specialist research houses. It is not uncommon for large US hedge fund groups to retain political consultancies in Washington to get a handle on the probabilities of regulatory change in various industries. Healthcare specialist funds might tap into firms that understand the workings of the FDA, or can interpret clinical trial data to commercial effect.

Leading hedge fund groups have enough capacity in research spending to commission their own research – footfall at malls or in particular chains of shops, interviews on the street with shoppers on particular brands, counting of cars at import terminals, or monitoring iron-ore ship-loads at Australian ports. Sometimes managers at different hedge fund management groups get together to fund such primary research. Student interns are sometimes brought in to carry out bespoke research projects.

A third initiative taken by hedge funds to obtain a demonstrable information edge is the use of expert network providers like Vista, Coleman, and Guidepoint Global. There were seven such firms just over ten years ago, and there are at least 24 operating today. The largest is Gerson Lehrman which is the only expert network company with a global network. It is instructive that Gerson Lehrman was founded (in 1998) by Mark Gerson and Thomas Lehrman who had spent the prior two years at hedge fund Tiger Management.

Of course, many hedge fund managers talk to their companies directly to produce an understanding of the companies in their universe, which can be an edge. Meetings with senior executives can be limited as sources of information, given what the executives feel able to disclose in Western countries. A common tactic to get some useful information from a company meeting is to talk and ask about competitors. It is often seen that investors pair up in company meetings – one staffer to ask the prepared questions and one to observe the body language and reactions of the executives. One manager I know seeks better operational level information by using extensive contacts at the level of divisional heads in the companies in his universe.

If you think about it, investors in distressed securities and activist investors try hard to put themselves in the position of being privileged investors. Distressed managers position themselves to be on the creditor committees which help decide how company financial reorganisations unfold. Activists seek Board representation. Being on the committee/Board puts them in a position of being better informed investors about the securities and companies to which they have exposure.

So a manager has information that he thinks is not priced into the market, even if he thinks several other investors know it too (the efficient market hypothesis being recognised as dead at this point). The information edge then has to be appropriately expressed in the fund's portfolio. This is where conviction and positive reinforcement should come in, but that is a whole other topic and would take us on to the dynamics of position sizing and portfolio construction – topics addressed in my consultancy but not here today.

Going back to when I was an investor in hedge funds at a fund of funds outfit, I used to ask managers of hedge funds in Europe about their information flows. I would only ask the managers in private meetings as this was not a topic for discussion in open forums like a Cap Into event. I don't recall a manager ever saying to me directly in this time (2001-2) that they had special or unique sources of information about stocks or companies. Finding out what the inputs to their process are is part of understanding how a manager operates. What sources they tap (and how frequently) is part of what helps you as an investor understand where the manager is on the spectrums: wholly fundamental through to wholly technical; long holding period investor through to short holding period trader; and where the manager is positioned in breadth versus depth in their universe.

So in conclusion, all hedge fund managers are required by investors to have an edge. Although the edge may theoretically be of different sorts (such as ability to forecast volatility or correlations, or time markets), often investors expect a hedge fund manager to have an information edge in some way. There is a significant bias amongst investors that the investment process of managers should be fundamentally driven, and this reinforces the desire amongst investors for an information edge to be part of the offering. In the pursuit of such an edge managers of hedge funds have made and continue to take significant initiatives to obtain for themselves proprietary information. Deep research and expertise justifies the (externally perceived) steep hedge fund fees. The trends are for hedge funds to devote more resources to acquiring the elusive information edge. Galleon allegedly did it the wrong way, but the information edge is worth persuing with most managers in the due diligence process.

DO YOU AGREE? DO YOU HAVE A COMMENT?

The Posting A difference between long only and hedge has a comment on it.

Do you agree with Doug of London, or was he just talking his own book?