How a Hedge Fund Manager Controls Risk in an Expensive Market

During their recent episode, Taylor, Carlisle, and Zeke Ashton discussed How a Hedge Fund Manager Controls Risk in an Expensive Market. Here’s an excerpt from the episode:

[Zeke] Oh yeah. I mean, shorting is quite risky as well. So to address the short thing to start with, I almost don’t short individual stocks anymore.
We tend to buy in the money puts if we want to go short something. And I say in the money usually so that we don’t pay a lot of time premium. But that way, if we’re shorting through an in the money put and the stock goes against us, the losses are non-recourse to us after a certain point and we don’t have to spend all of our time trying to manage risk limits and this sort of thing.

And it prevents the kind of crazy loss that you can have. Imagine if you had been unlucky enough to be short GameStop and probably you were short GameStop with very good reason. And then it just turns into this self-fulfilling crazy loss.

It would be very easy to blow up if you had a meaningful exposure on the short side to GameStop. And so as far as things I look at from the risk management side, the number one thing I’m looking at now is, is my exposure truly diversified? Are my best ideas diverse from each other?

So we talked about the exchanges. We obviously have a little basket of them, but I’ve limited the amount of the portfolio that we will have in not only exchanges, but things that are pro-cyclical or pro-capital cycle like that. And then I would say the AI winner-loser thing.

As soon as it became clear to me that I would look at my portfolio and I’d have five stocks that were all down on an up-market day and they didn’t have anything that really connected them from a traditional factor standpoint or they’d be in very different industries. And it obviously occurred to me that, hey, they’re being considered to be AI losers or at least AI vulnerable, even though in my view, they were very different investment ideas. And basically we put a limit on, hey, if it acts like an AI loser on a day-to-day basis, I’m going to assume that that’s a brand new factor that I have to consider.

And so we won’t go more than 20% of our portfolio in those kinds of names. And that’s helped us to reduce volatility in our fund. But it also has, in some ways, reduced how much profit we can have when there’s sort of an unwind of the AI winner-loser basket, like there was in July.

We could have made more money if we’d had more software and more things like that. So it is one of those things where I think, and I’m going to use the word creative again, like you just have to be creative about looking at your portfolio every day and saying, hey, in this scenario, if this were to happen, what would happen to this stock, this stock, this stock, this stock, and what’s it correlated with? And then on the short side, I think you want to avoid your short side being what I’m going to call the photo negative of your long side, which you don’t want it just to be the opposite of your longs.

You don’t want it to be the anti-long portfolio. You want basically each one of those to have some vulnerability that you believe is likely to show up in the near term. And again, using puts really helps to limit the amount of damage they can cause you while still giving you full exposure to the downside, if you’re right.

[Jake] You want to be a little more aware of your situation.
[Tobias] Situationally aware.