Secular trends in L/S investing
How do L/S shops and pods think about secular trends? How much does the underlying sector story matter in investment decision?
Many hedge funds claim they are looking for idio opps and operating market neutral / sector neutral strategies. How do they implement it in reality? Do they always execute pair trade or under what circumstances they don’t? For example, do investors long NVDA and short AMD, intentionally not caring about the tailwind in advanced chips?
Appreciate any insights!
Don’t always do pairs
Play tailwinds via exposure and positioning I.e X’s product mix is superior and will take pricing vs Y as demand grows from thematics. Mkt underestimating Y ability to scale as a result, and X has limited earnings upside due to estimates being high. Long Y short X.
Simplifying a lot but the story does matter. Stocks are stories
Plz excuse me if I misunderstood, but it seems like what you just described is a pair trade. Maybe that was the intention, but you started off by saying you don’t always do pairs. Would you mind giving an example of how you’d approach the same secular tailwind (AI hype generating heightened demand for advanced chips) with a L/S investment and achieve the ideal exposure and positioning without executing a pair trade? Thanks!
Most pair trades leave you with net exposure to a tailwind. Few pair trades truly cancel out everything but the idio. Can you name two companies with identical customer end market exposures?
Bottom line is that secular trends matter. But you're solving for mispricings relative to views rather then betting on a secular trend per se.
Rarely will a portfolio be only long-term secular geared just as it's rarely only near-term catalyst / earnings-based. They could be tilted to one or the other depending on PM skill/expertize, style, or simply current read on the market. Different stocks trade on different things. E.g. thematic/secular views (positive and negative) with earnings serving as interim proof points towards the secular bet (perhaps more prone to sizing alpha then ideation alpha)... And flipside being "show me" stocks where I need clear earnings evidence / metrics to gain conviction in the thesis.
I find that most PMs, for a lack of a better word, conduct "risk bucketing" and try to have a degree of timeframe diversification so you avoid too much ST or LT momentum and/or reversal risk in your portfolio construction.
I want a certain mix of shorter-term catalyst trades, medium-term fundamental positions, and longer-term secular theme exposure (dynamic weighting of these depending on current opportunity set). I want to maximize my ability to monetize whatever comes my way (within my coverage and risk limits) that offers asymmetry, with a diversified timeframe. Perhaps more then anything just to calibrate my risk metrics to desired levels at any given point in time.
If I'm honest, my view of secular vs. near-term catalyst takes a backseat to price action. If I have a LT view, and the bet expression narrows to my return target sooner than expected then I take profit. I could hold it for longer, but then it's a new bet. And I'd need to re-underwrite the position for a new return hurdle with a new risk/reward skew that I'd be forced to compare to other alpha opportunities.
Equally, if a ST bet is not working within a specific time frame I'll cover my losses. They can also move from ST views to secular bet depending on emerging views/new information.
These can be expressed differently (not exhaustive):
Relative pairs (Long A / Short B) within subsectors → isolating company-specific factors (management execution, product cycles, market share shifts)
Single Stock vs Basket → Long or short a high-conviction name vs basket of peers. Helps isolate idiosyncratic opportunity while hedging sector risk
Factor-Based Positions → No real single security bet, but helps risk manage the book and dispose of unwanted exposures
Catalyst-Driven Trades → Corp action, short report, reg headlines... and I guess Trump tweets going forward? (fml...). Can be expressed through single name or any of the above if I have enough risk budget to allocate within the risk framework. I tend to leave a little bit of risk budget & GMV for these type of situational opportunities for when they arise.
Very helpful. Of the below, am i correct in thinking that the average pod at Big 4 only has (i) at their disposal (generally speaking)? And within (i), they can only express it via pair trades?
(i) shorter-term catalyst trades, (ii) medium-term fundamental positions, and (iii) longer-term secular theme exposure.
Rarely restricted to just pair trades. The risk framework is about managing exposures rather than forcing specific trade constructions. 'Classic' Pair Trade may be the bread and butter for many, but there's also distinctions between "paired" positions vs true pair trades. You can be long NVDA / short SMH (Semi's ETF) to express company-specific view while maintaining sector exposure. Or long ASML / short AMAT for pure relative value. Both could be considered as a pair.
What do you want to know?
As far as first principles go: Stock return = idiosyncratic + market/factor. Idiosyncratic returns = selection + sizing + timing. Because markets move factor loadings change so we need to rebalance often to bring in unintended risk to acceptable levels. We measure this through volatility/VaR towards a specific factor loading. Idio VaR / Total VaR.
Impossible to 100% hedge any factor (if you could it would imply you could perfectly predict the future and in that case you wouldn’t even need to hedge). While some factors have persistent alpha (few), many are highly cyclical and mean-reverting.
Say you run a portfolio with annualized vol of $XM with a 80/20 idio/factor target, so 20% x $XM = $YM of vol can be driven by the market. Y moves up and down (esp around big market moves). Great variety among PM’s how they manage this.
Can be through simple marginal risk-reducing trades (just single names offsetting some unwanted risk), portfolio optimization baskets (tailored for you from banks, usually free, they earn commission when you trade it), systematic factor hedging through your traders, PM actively trading off-the-shelf factor portfolios (again from banks) or sector / niche indices, or some type of fully automated factor portfolio management. There's great tech embedded in the systems to help you optimize your portfolio at any half decent manager in this day and age.
Can you elaborate a bit more on factor based positions?
Good thread
It depends on the strategy and your ability to run net long or short. It’s harder to be long secular trends because they’ll accumulate momentum and that’ll put you offsides in a factor model.
You definitely can run it on the edges but it’s harder to put on a trade like long NFLX short Media because the model will tell you that it’s too momentum driven
I tend to think that being long secular winners and short secular losers is an incredible trade if you can stomach drawdowns but I’m not at a pod shop
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