THE HEDGER
FINAL EDITION
On 4/09/98 Russell Equity Management ceased publishing THE HEDGER.
THE HEDGER
Volume 3, Issue 15.
04/09/98
Copyright (C) 1998, Russell Equity Management
All Rights Reserved
OBJECTIVE: To minimize market exposure while simultaneously outperforming
the SP500 Index on both a nominal and risk-adjusted basis via an
unleveraged hedged common stock portfolio.
INTRODUCTION:
To hedge is to protect oneself from financial loss by a counterbalancing
transaction that minimizes risk. To minimize overall stockmarket exposure
or risk, one can hedge by purchasing stocks that will rise more than the
market while simultaneously selling short stocks that will decline more than
the averages.
Webster defines a hedge fund as "an investing group that employs speculative
techniques in the hope of obtaining large capital gains". In the US, hedge
funds are private pools of capital organized as limited partnerships with 99
or fewer "accredited" investors (i.e. those with a net worth of $1 million
and incomes greater than $200,000). These funds have high minimum
investments averaging $100,000 to $250,000 with hedge fund managers taking
15% to 25% of the total profits in addition to management fees of 1% to 2% of
total assets. By US law hedge funds can not advertise or market themselves,
but independent consultants who maintain proprietary databases on hedge
funds assist in the placement of partners.
The first hedge fund appeared in the US in 1949, the beginning of the post
World War II US economic boom. Founded and managed by Alfred Winslow Jones,
an academic and journalist who had taken up the stock market as a hobby,
this private fund used leverage (i.e borrowed funds/securities) and balanced
stock purchases with short sales to achieve maximum profit while
simultaneously minimizing market fluctuations. Believing his portfolio was
protected from market downdrafts, Jones aggressively traded the long side of
his portfolio by acquiring "momentum stocks" in the early stages of their
levitations. Jones' fund generated huge commissions of which roughly 50%
went to "special brokers" in the form of "give-up checks" in return for what
might be euphemistically labeled "research".
Jones' record was outstanding. By 1966 he and his partners had sextupled
their money while the Dow Jones Industrials, which had risen broadly and
steadily over the same time period, slightly more than doubled. After
experiencing only one losing year in 1962 the fund achieved several years of
75% to 80% annual returns in the mid 1960's. Such success bred competition
as other funds such as City Associates and Fairfield Partners climbed aboard
the bandwagon. As the 1960's flew on, Jones' and his contemporaries long
positions became increasingly concentrated in the same stocks as were being
held by the most aggressive mutual funds of the era. Many of these holdings
were small capitalization issues.
The huge and seemingly guaranteed returns these funds generated during this
period attracted many unwary investors to hedge funds, most of which were
greatly disappointed as the market peaked in 1968 and then eroded 26% in
1974. In the end the expected reduction in risk from the shorting of stock
was an illusion for hedge funds as a group lost over 70% of their assets.
In retrospect the majority of Jones' success was due to:
1. his fund having a net long market exposure over a long period of
steady economic growth.
2. the use of leverage, which amplified the positive returns of long
positions.
3. establishing early entries and exits in "momentum stocks".
The record shows that after transaction costs Jones, as with all his
contemporaries, was lucky to break even on his short positions. Due to the
long-term upward bias of the US stockmarket the most difficult job for
hedgers has been the consistent selection of profitable short sales. In
1936 Benjamin Graham's Graham-Newman Corporation simultaneously employed six
different investment techniques, one of which was "hedged investing" (i.e.
being short one security and long another that had no relation to the
first). By 1939 Graham-Newman abandoned "hedged investing" as performance
statistics showed it had not worked well enough to justify continuance.
In Webster's definition of "hedge fund", the key words are "speculative" and
"large capital gains". Today, the hedge fund industry manages over $100
billion in assets with the 12 largest funds controlling over 50% of the
total. These huge funds which feature such names as Soros, Robertson,
Steinhardt, Tudor Jones and Hempleman use borrowed funds and aggressive
speculative tactics to produce outstanding capital gains and losses.
Although current hedge fund holdings are not overweighted in US stocks as
they were in the 1960's, undoubtably their more profitable holdings are
illiquid and impossible to hedge completely.
One realizes the current hedge fund "game" is played similarly to the "game"
of Player A in the appendix below and that the true promise of a "hedged"
fund, that of superior performance with reduced risk, has never been
consistently achieved solely with common stocks. We will address this void
by introducing a new hedge fund category labeled "Long Index / Short
Equities", but first lets review some basic hedge fund concepts.
HEDGE FUND TERMS & EXAMPLES:
Leverage: the percentage of assets long plus the percentage of
assets short.
Net Market Exposure: the percentage of assets invested long minus the
percentage of assets invested short.
Hedge Fund A pools $200 million from its partners and borrows $20 million,
$160 million of stock is purchased and $60 million of stock is sold short.
Fund A is leveraged 110%, (160/200 + 60/200) = (80% + 30%). Fund A is
biased on the long side by 50%, (80% - 30%). The leverage of Fund A
increases the risk of the portfolio but the volatility of broad market
movements should be minimized via its "relatively" low market exposure. In
theory the combination of leverage and reduced market exposure should enable
Fund A to outperform the market averages on both a nominal and risk adjusted
basis.
Hedge Fund B pools $200 million from its partners, $100 million of stock is
purchased and $100 million of stock is sold short. Fund B is NOT leveraged
and its market exposure is 0%.
THE HEDGER'S STRATEGY:
THE HEDGER's strategy will follow the example of Hedge Fund B above, as a
result THE HEDGER'S "model poirtfolio" will be unleveraged with zero net
market exposure. On the long side to capture the long-term upward bias of
the US stockmarket we simply "buy the market" through the purchase of SP500
Depositary Receipts, aka "SPDRs" or "spiders". SPDRs trade under the symbol
(SPY) and are quoted at values 1/10 of the SP500 Index. SPDRs are units of
a trust which holds the SP500 stocks in proportion to their index weighting.
These units pay quarterly dividends based on the accumulated dividends payed
by the underlying SP500 stocks with the trust charging .19% of principal to
cover expenses. SPDRs can be bought at intraday prices with market, limit,
at open or at close orders. SPDRs can also be sold short. These
characteristics give SPDRs more flexibility than Index mutual funds.
On the short side, IPO, concept, story, bubble, negative net worth and
negative current earnings stocks with PE multiples that are unreasonable
are prime candidates. These situations are particularly favored when there
is a high degree of institutional ownership or they are traded on a
"dealers market" were a declining number of broker-dealers are "making a
market" for said candidate. Usually these situations depend too much on
investor enthusiasm which is an emotional response, in the long run emotion
and money do not mix well.
Within this theme we pursue only LOW RISK short sales, (risk defined here as
the probability of incurring a loss of principal). To cull LOW RISK trades
we analyze each candidate with two proprietary systems, "Risk Return
Profile" and "Flow of Funds".
"Risk Return Profile" analyzes the recent price history of a company's stock
and generates a rating that is compared to a theoretical "riskless" return.
The system answers the following question. Does the recent capital
appreciation/depreciation of a stock adequately compensate a trader for the
risk assumed in establishing a position? (for a discussion of risk and return
see appendix)
If the answer to the above question is "no", we try to confirm it by using
"Flow of Funds", a ticker tape analysis program that analyzes all trades
made in a particular stock during the past year. "Reading the tape" has
become somewhat of a lost art yet it aids in quantifying the RISK
surrounding a potential trade. Analyzing the ticker tape allows us to
categorize stocks into three groups, (low risk, risk neutral, and high
risk). On the short side HIGH RISK situations (i.e those with a lack of
buying power and increasing selling strength) are favored.
PORTFOLIO MANAGEMENT RULES:
THE HEDGER's "model portfolio" will conform to the following rules.
1. A hypothetical $1,000 will be applied to all trades entered.
2. Every short sale will be counterbalanced by an equivalent purchase of
SPDRs.
3. No margin will be used, short sales must be funded 100% by cash balances
present in the "model portfolio" on the trade date.
4. Unrealized capital gains from existing positions may not be used as cash
balances to fund future trades.
5. The "model portfolio" will be re-balanced to zero net market exposure
when an existing short position is covered. This is done to minimize
hypothetical transaction costs and render the "Transaction Report"
more readable,
THOUGHTS ON SHORT SELLING:
Readers not familiar with the short-selling of stock should be aware of the
"short squeeze". If you do not know what this entails we strongly urge you
not to enter this game. Stocks that have attracted much short-selling
interest, are seemingly overvalued, have exhibited strong recent price
action, and for one reason or another are hard to borrow in the open market,
may be prime candidates for a "short squeeze". Your broker can provide you
with valuable information and advice regarding whether or not to short any
of our highlighted stocks.
NOTE:
THE HEDGER does not follow dividend payments thus the returns for the
"model portfolio" reflect only capital appreciation/depreciation.
THE HEDGER is posted to our web page for registered users and emailed
to trial subscribers on weekends no later than Sunday 12 midnight EST.
============================================================================
MODEL PORTFOLIO RECORD
----------------------
10/13/95 - 04/09/98
Return excluding commissions: 130.78%
SP500 (584.50 - 1110.66) : 90.00%
Total Trades 32
Winners 28
Losers 4
SUCCESS RATE: 87.5%
===============================================================================
PERFORMANCE STATISTICS (05/03/96 - 04/03/98)
P. SHARPE RATIO AVG.of WEEKLY YTD RETURNS as % STANDARD DEVIATION
-- ------------ ------------------------------ ------------------
A 2.10810399055481 62.53180313110352 27.1124095916748
B 1.379873275756836 29.39589309692383 17.40731430053711
A = Hedger Model Portfolio
B = SP500 Index
*note see appendix below for discussion of Sharpe Ratio.
===============================================================================
PORTFOLIO REPORTS
Transactions
-------------
Date TAC Symbol Description Quantity $/U Com/Fees $ Amount
-------- --- --------- --------------- ---------- -------- -------- -----------
10/13/95 SLS SPCT Spectrian Corp -48.1928 20.75 1000.00
10/13/95 BUY SPY SP500 Depositor 17.0576 58.63 -1000.00
10/13/95 DPF Cash 2000.00
12/29/95 DPF Cash 2000.00
12/29/95 SLS STAT I-Stat Corp -30.7692 32.50 1000.00
12/29/95 BUY SPY SP500 Depositor 16.2644 61.48 -1000.00
01/19/96 SLS MWHS Micro Warehouse -31.25 32.00 1000.00
01/19/96 BUY SPY SP500 Depositor 16.3225 61.26 -1000.00
01/19/96 DPF Cash 2000.00
06/21/96 SLS RAYS Sunglass Hut In -40.404 24.75 1000.00
06/21/96 BUY SPY SP500 Depositor 14.9674 66.81 -1000.00
06/21/96 DPF Cash 2000.00
07/19/96 SLS AOL America Online -30.5344 32.75 1000.00
07/19/96 BUY SPY SP500 Depositor 15.6328 63.97 -1000.00
07/19/96 DPF Cash 2000.00
07/26/96 BYC STAT I-Stat Corp 30.7692 12.25 -376.92
07/26/96 SLL SPY SP500 Depositor -39.8264 63.72 2537.66
07/26/96 WDF Cash -4160.74
08/09/96 SLS FORE Fore Systems In -31.3725 31.88 1000.00
08/09/96 BUY SPY SP500 Depositor 15.1016 66.22 -1000.00
08/09/96 DPF Cash 2000.00
10/11/96 SLS SHVA Shiva Corp -22.0994 45.25 1000.00
10/11/96 BYC RAYS Sunglass Hut In 40.404 8.50 -343.43
10/11/96 WDF Cash -345.75
10/11/96 BUY SPY SP500 Depositor 4.4206 70.31 -310.82
10/18/96 SLS REGL Regal Cinemas I -39.604 25.25 1000.00
10/18/96 BUY SPY SP500 Depositor 14.0414 71.22 -1000.00
10/18/96 DPF Cash 2000.00
11/01/96 SLS FEET Just For Feet I -40 25.00 1000.00
11/01/96 BUY SPY SP500 Depositor 14.1657 70.59 -1000.00
11/01/96 DPF Cash 2000.00
12/13/96 SLS FLH Fila Holdings ( -16.5289 60.50 1000.00
12/13/96 BUY SPY SP500 Depositor 13.6403 73.31 -1000.00
12/13/96 DPF Cash 2000.00
12/20/96 BYC MWHS Micro Warehouse 31.25 11.63 -363.28
12/20/96 SLL SPY SP500 Depositor -13.6361 74.84 1020.57
12/20/96 WDF Cash -2657.30
12/27/96 SLS PZZA Papa Johns Intl -30.7106 32.56 1000.00
12/27/96 BUY SPY SP500 Depositor 13.1796 75.88 -1000.00
12/27/96 DPF Cash 2000.00
01/03/97 SLS DSP DSP Communicati -49.6894 20.13 1000.00
01/03/97 BUY SPY SP500 Depositor 13.3168 75.09 -1000.00
01/03/97 DPF Cash 2000.00
01/10/97 SLS CSCC Cascade Communi -17.5055 57.13 1000.00
01/10/97 SLS RAIN Rainforest Cafe -41.3445 24.19 1000.00
01/10/97 BUY SPY SP500 Depositor 26.2726 76.12 -2000.00
01/10/97 DPF Cash 4000.00
01/17/97 BYC SPCT Spectrian Corp 48.1928 9.75 -469.88
01/17/97 SLL SPY SP500 Depositor -9.5637 77.56 741.78
01/17/97 WDF Cash -2271.89
01/24/97 SLS AAM Aames Financial -24.2424 41.25 1000.00
01/24/97 BUY SPY SP500 Depositor 26.0586 76.75 -2000.00
01/24/97 SLS CHK Chesapeake Ener -39.0244 25.62 1000.00
01/24/97 DPF Cash 4000.00
01/31/97 BYC SHVA Shiva Corp 22.0994 18.06 -399.16
01/31/97 SLL SPY SP500 Depositor -17.4374 78.41 1367.20
01/31/97 WDF Cash -2968.03
02/24/97 SP- AAM Aames Financial -12.1212 0.00
03/07/97 SLS PAIR Pairgain Techno -33.195 30.12 1000.00
03/07/97 BUY SPY SP500 Depositor 12.3697 80.84 -1000.00
03/07/97 DPF Cash 2000.00
03/14/97 BYC AOL America Online 30.5344 43.75 -1335.88
03/14/97 SLL SPY SP500 Depositor -36.7258 79.69 2926.57
03/14/97 WDF Cash -3590.70
04/11/97 SLS PSFT PeopleSoft Inc -29.1971 34.25 1000.00
04/11/97 BUY SPY SP500 Depositor 13.6286 73.38 -1000.00
04/11/97 DPF Cash 2000.00
04/18/97 BYC DSP DSP Communicati 49.6894 7.75 -385.09
04/18/97 SLL SPY SP500 Depositor -27.1543 76.56 2078.99
04/18/97 WDF Cash -3693.90
04/25/97 BYC FORE Fore Systems In 31.3725 11.63 -364.71
04/25/97 SLL SPY SP500 Depositor -5.2111 76.53 398.81
04/25/97 WDF Cash -2034.10
05/30/97 BYC REGL Regal Cinemas I 39.604 32.87 -1301.98
05/30/97 SLL SPY SP500 Depositor -10.2884 85.16 876.12
05/30/97 WDF Cash -1574.14
06/20/97 BYC PSFT PeopleSoft Inc 29.1971 54.75 -1598.54
06/20/97 SLL SPY SP500 Depositor -21.3204 89.58 1909.84
06/20/97 WDF Cash -2311.29
06/27/97 BYC CHK Chesapeake Ener 39.0244 9.13 -356.10
06/27/97 SLL SPY SP500 Depositor -8.6385 88.91 768.02
06/27/97 WDF Cash -2411.92
06/30/97 BYC CSCC Cascade Communi 17.5055 27.63 -483.59
06/30/97 SLL SPY SP500 Depositor -5.2264 88.31 461.56
06/30/97 WDF Cash -1977.97
08/08/97 BYC AAM Aames Financial 36.3636 21.50 -781.82
08/08/97 BYC FLH Fila Holdings ( 16.5289 30.94 -511.36
08/08/97 SLL SPY SP500 Depositor -14.7347 93.37 1375.85
08/08/97 WDF Cash -4082.67
01/16/98 SP- RAIN Rainforest Cafe -20.67225 0.00
03/20/98 BYC RAIN Rainforest Cafe 62.01675 15.13 -938.00
03/20/98 BYC PAIR Pairgain Techno 33.195 21.00 -697.10
03/20/98 SLL SPY SP500 Depositor -18.620796 109.87 2045.96
03/20/98 WDF Cash -4443.05
04/09/98 **CASH*** Closing Balance 0.00 3967.82
Portfolio Positions - 04/09/98
-------------------------------
T Symbol Description Quantity $ Cost Mkt Price $ Value Val %
- --------- --------------- ---------- ----------- --------- ----------- -----
**CASH*** 3967.82 3967.82 101%
S FEET Just For Feet I -40 -1000.00 20.3120 -812.48 -21%
S PZZA Papa Johns Intl -30.7106 -1000.00 40.2500 -1236.10 -31%
S SPY SP500 Depositor 18.0560 1305.52 111.1870 2007.60 51%
----------- ----------- -----
-694.48 -40.98 -1%
----------- ----------- -----
Portfolio Total 3273.34 3926.84 100%
Capital Gains 10/13/95-04/09/98
--------------------------------
Symbol Descrip Quantity Buy Date SellDate $ Sales Cost Basis Gain/-Loss
--------- --------- --------- -------- -------- ---------- ---------- ----------
STAT I-Stat Co -30.7692 07/26/96 12/29/95 1000.00 376.92 623.08
SPY SP500 Dep 17.0576 10/13/95 07/26/96 1086.87 1062.85 24.02
SPY SP500 Dep 16.2644 12/29/95 07/26/96 1036.33 1013.43 22.90
SPY SP500 Dep 6.5045 01/19/96 07/26/96 414.45 405.29 9.16
SPY SP500 Dep 9.8181 01/19/96 12/20/96 734.81 658.72 76.09
SPY SP500 Dep 3.8181 06/21/96 12/20/96 285.76 256.17 29.59
SPY SP500 Dep 9.5637 06/21/96 01/17/97 741.78 672.85 68.93
SPY SP500 Dep 1.5856 06/21/96 01/31/97 124.32 113.23 11.09
SPY SP500 Dep 15.6328 07/19/96 01/31/97 1225.71 1116.39 109.32
SPY SP500 Dep 0.2190 08/09/96 01/31/97 17.17 15.64 1.53
SPY SP500 Dep 14.8826 08/09/96 03/14/97 1185.95 1074.21 111.74
SPY SP500 Dep 4.4206 10/11/96 03/14/97 352.26 319.07 33.19
SPY SP500 Dep 14.0414 10/18/96 03/14/97 1118.92 1013.49 105.43
SPY SP500 Dep 3.3812 11/01/96 03/14/97 269.44 244.05 25.39
SPY SP500 Dep 10.7845 11/01/96 04/18/97 825.68 779.77 45.91
SPY SP500 Dep 13.6403 12/13/96 04/18/97 1044.33 986.26 58.07
SPY SP500 Dep 2.7295 12/27/96 04/18/97 208.98 197.36 11.62
SPY SP500 Dep 5.2111 12/27/96 04/25/97 398.81 376.79 22.02
SPY SP500 Dep 5.2390 12/27/96 05/30/97 446.13 378.80 67.33
SPY SP500 Dep 5.0494 01/03/97 05/30/97 429.99 365.10 64.89
SPY SP500 Dep 8.2674 01/03/97 06/20/97 740.58 597.77 142.81
SPY SP500 Dep 13.0530 01/10/97 06/20/97 1169.26 943.79 225.47
SPY SP500 Dep 8.6385 01/10/97 06/27/97 768.02 624.61 143.41
SPY SP500 Dep 4.5811 01/10/97 06/30/97 404.56 331.23 73.33
SPY SP500 Dep 0.6454 01/24/97 06/30/97 57.00 46.66 10.34
SPY SP500 Dep 14.7347 01/24/97 08/08/97 1375.85 1065.39 310.46
RAYS Sunglass -40.404 10/11/96 06/21/96 1000.00 343.43 656.57
MWHS Micro War -31.25 12/20/96 01/19/96 1000.00 363.28 636.72
SPCT Spectrian -48.1928 01/17/97 10/13/95 1000.00 469.88 530.12
SHVA Shiva Cor -22.0994 01/31/97 10/11/96 1000.00 399.16 600.84
AOL America O -30.5344 03/14/97 07/19/96 1000.00 1335.88 -335.88
DSP DSP Commu -49.6894 04/18/97 01/03/97 1000.00 385.09 614.91
FORE Fore Syst -31.3725 04/25/97 08/09/96 1000.00 364.71 635.29
REGL Regal Cin -39.604 05/30/97 10/18/96 1000.00 1301.98 -301.98
PSFT PeopleSof -29.1971 06/20/97 04/11/97 1000.00 1598.54 -598.54
CHK Chesapeak -39.0244 06/27/97 01/24/97 1000.00 356.10 643.90
CSCC Cascade C -17.5055 06/30/97 01/10/97 1000.00 483.59 516.41
AAM Aames Fin -36.3636 08/08/97 01/24/97 1000.00 781.82 218.18
FLH Fila Hold -16.5289 08/08/97 12/13/96 1000.00 511.36 488.64
RAIN Rainfores -62.01675 03/20/98 01/10/97 1000.00 938.00 62.00
PAIR Pairgain -33.195 03/20/98 03/07/97 1000.00 697.10 302.90
---------- ---------- ----------
Capital Gains (Short Term) 32462.96 25365.76 7097.20
SPY SP500 Dep 10.678545 01/24/97 03/20/98 1173.31 772.11 401.20
SPY SP500 Dep 7.942251 03/07/97 03/20/98 872.65 574.26 298.39
---------- ---------- ----------
Capital Gains (Long Term) 2045.96 1346.37 699.59
===========================================================================
===========================================================================
===========================================================================
THE HEDGER MODEL PORTFOLIO
TRADE RECOMMENDATIONS
NO RECOMMENDATIONS FOR THE WEEK ENDING 04/09/98.
============================================================================
SYMBOL KEY
DPF = CASH DEPOSIT OF FUNDS WDF = CASH WITHDRAWAL OF FUNDS
BUY = BUY SECURITY SLL = SELL SECURITY
SLS = SELL SECURITY SHORT BYC = BUY TO COVER SHORT POSITION
SP+ = SPLIT LONG SP- = SPLIT SHORT
T = TYPE OF INVESTMENT S = STOCK
$/U = PRICE PER SHARE M = MUTUAL FUND
TAC = TRANSACTION CODE $/COST = TOTAL INVESTMENT
DV+ = CASH DIVIDENDS PAID QUANTITY = # OF SHARES HELD
ss = SHORT SALE
============================================================================
NOTES ON PORTFOLIO RETURN COMPUTATION
The Return on Investment for the "Model Portfolio" and the SP500 is computed
by determining the Internal Rate of Return (IRR). All transactions are
converted to a series of cash flows (positive, negative, or null) and the
following equation is solved.
NPV = 0 = Sum((CF(i) / ((1+Rate)^(Date(i)-Date(0))))) - Internal Valuation
where:
NPV = Net Present Value
CF(i) = Cash Flow for transaction (i)
Rate = (Return on Investment)/100
Date(i) = Date of the (ith) transaction (years & fractions of years, 365.25
days per year assumed
Date(0) = Starting date of the portfolio valuation
^ = exponential notation (e.g. 3^2 = 9)
Sum = Signifies to sum for all transactions starting with the first
transaction following the start date specified, up to and
including all transactions on the close date.
**Note: In calculating the cost basis of the portfolio we assume 100% margin
requirements for each stock. If a portfolio consisted of 7 stocks
(six long, one short) the cost basis would be $7,000.
RETURN TO ARCIHVES