Why One Money Manager Shorts Stocks

Veteran portfolio manager Dan Knight (pictured at right) practices an investing strategy that has a strong history of outperforming the market. In this interview, Eliot Penn, Dan's fellow Investment Director at Vestopia, picks Dan's brain to learn the secrets of this former blackjack dealer's outperformance.

Eliot: You're a rare bird running your personal portfolio with a long/short strategy where most investors are long only. Why short stocks, especially when the market seems to go up over the long run?

Dan: Rare bird, or bird-brained, I'm trying not so much to short stocks outright but in conjunction with hedging attractive long positions. I aim to earn a positive spread return between my longs and my shorts, that is my longs go up more than the shorts in an up market, or my shorts fall more than the longs in a down market, while still taking little net exposure to the stock market. If I do my job right, I'll create a risk/return profile that not only earns a positive return, but does so with far less risk, volatility, and correlation to traditional equity investments.

Eliot: Am I understanding correctly that, generally speaking, for each long position you'll have a corresponding short position to offset some of the risk?

Dan: Yes. I generally try to "pair" a short to each long, though that doesn't mean that the short is a direct business competitor to the long, just a stock that comes from either the same industry or economic sector.

Eliot: I see. What about the risk of being wrong on both sides, i.e. your long goes down and your short goes up? In attempt to reduce volatility, might you actually be at risk of increasing it?

Dan: That is possible, but that is where portfolio construction and strategy diversification come into play. For each sector, I have a different style-blended model to identify the longs and shorts. That makes losing money simultaneously on both the long and short side much less likely than if I used a common theme or investment process across the board.

Eliot: In other words, are you saying that within the long side and within the short side you reduce risk through your diversification strategy?

Dan: Correct, and ideally one should try to hold a larger number of total positions to minimize company-specific risk. At the present, I hold about 20 names long, 20 short. William Sharpe, father of the Sharpe ratio, referred to market neutral strategies as the purest display of stock picking skill, since the shorts offset the longs so any profits come from the manager's skill, not from an overall rise in the market.

Eliot: So in a nutshell, you short stocks with the dual goal of reducing risk and earning great returns. A tall order, but certainly a desirable one. Thanks, Dan, for shedding light on your thinking. In Part 2 of this interview we'll discuss how your hedged strategy has been holding up lately, and a few of your current holdings.

Go to part 2 >>

PS - You can read Dan's trading blog and see his portfolio holdings right here.

Comments

[omooc]

There is nothing new in this story. Why bother to write?

[Yazz]

I enjoyed hearing how Knight thinks about his strategy even if he's not the only one doing paired trades, and I liked part II where he gave examples of applying his strategy to real picks