Hedging style factors L/S
Hi guys,
So I am running a long short portfolio for a while, and although I have quite decent returns, I am more and more interested in the way big L/S funds operate.
For the past year I have only been hedging out beta and now size (since I had some losses when small caps rallied), and got fairly well returns by adjusting sector exposure.
One thing I can’t wrap my head around is the fact that there are a lot of funds that aim to hedge out a lot of style factors such as quality/value/low vol/momentum etc. The reasoning behind this is unclear to me, yes I understand by hedging these out you get more uncorrelated returns and your portfolio vol goes down, but for example, wouldn’t you always want to be long high quality stocks and short junk? It seems to me that you always want multifactor exposure on the long side to these risk factors and low exposure to these risk factors on the short side, or isn’t this the way these funds operate? It also feels like by hedging out all these style factors you also severely limit your amount of investment opportunities. It seems hard to believe that if you need to hedge out size, sectors, and all the style factors, you can make the optimal stock pick.
Also if you run a personal L/S portfoli of 12 to 16 names, would you want exposure to these factors on the long side or would you hedge them out like a fund would? Or would you want to time these factors? If not, could you maybe look at the volatility between the hi-lo of the factors, for example, if high quality/low quality ratio chart is very volatile over the past months, but large cap/small cap is not, that you then decide you are not hedging size but you are quality?
I'd like to hear your thoughts
Thanks!
I don't know why people think all PMs at the big funds run mostly factor-neutral books. Someone correct me if I'm wrong but unless you are at Citadel where they literally force you to adhere strictly to their limits, most other places give you flexibility and many of the best PMs are paying attention to exposures but not as rigorously as people think they do.
To your question, though, the reason they might look to hedge out most factors is because of their holding period. On a long enough horizon, you want to have factor exposure on the long side, but if you are getting in and out of a position weekly or monthly, volatility, R/R, and what drives the stock are completely different.
Ngl - even at citadel some of the factor exposure hedging is bogus. You just need a certain amount of idiosyncratic/residual risk and the rest is all yolo. I disagree with the notion of wanting to always be long quality. Yeah most have some quality bias but trust me when I say things can go tits up if you you’re tilted heavily that way. Rotations can hurt really bad. So sometimes it’s worth being short quality or long some non quality companies where you have a negative or positivr view on actual fundamentals. Helps smoothen vol and keep your career afloat longer lol
There's so much money in that space following the same exact trades, some people have alluded to overcapacity, even market netural you're susceptible to what they do
2007 is one example of what could happen and that was when the strategies were less popular
They could also all underperform at the same time, some funds from aqr where you can see this
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