Refining the Investment Universe

Market participants usually find the vastness of the market quite intimidating. Thus, before we start putting the ideas we've covered in previous chapters into a combined investment strategy, we will dedicate a short chapter to reducing the market to a manageable investment universe.

In this chapter, we will start with some conceptual blind spots of the long/short business in an attempt to provide some valuable context to the real world you will be trading in. Next, we will follow the money to uncover what investors really want, by considering some major incidents and topics that have shaped the way that traders and markets operate.

We will cover the following topics:

• Avoiding short selling pitfalls
• What do investors really want?

Avoiding short selling pitfalls

This section is all about applying smart filters to avoid classic short selling pitfalls. Practitioners may hopefully revisit some of those points as they become more familiar with short selling. Most of the points here come from painful experiences.

Liquidity and market impact

Liquidity is the currency of bear markets. If you cannot get out of a position without significant market impact, you do not own anything. It owns you. The way to approach liquidity on the short side is radically different. On the long side, liquidity increases as more investors are drawn to rising prices. Early birds end up selling to a much larger pool of market participants.

On the short side, when investors liquidate their positions, it is a one-way street. After a beating, they don't come back for round two. Nothing captures the emotional journey of long market participants more faithfully than the Kübler-Ross model. Market participants grieve...

What do investors really want?

The long/short industry seems to go through a severe existential crisis every time the market "hits a soft patch." Investors are rudely reminded that downside protection only means limited downside with virtually no upside. The industry has operated from a "build it and they will come" product supply model. If the objective is to build sustainable businesses, it is high time we paused and looked at the world from an investor's perspective. This will provide crucial context to build a long/short product that meets investors' demands step by step.

Lessons from the 2007 quants debacle

"And so castles made of sand,
melt into the sea,
eventually."

– Jimi Hendrix

In August 2007, cross-sectional volatility took markets around the world by surprise. Although indices did not move much, constituents jumped across the board for a few days. Soon, rumors of unwinding from various quantitative...

Summary

This short chapter is not meant to test the braincells of the reader. It is simply a collection of practical tips on how to avoid classic expensive pitfalls and meet investors' expectations. Investors do not buy into long/short products for long ideas. They want low-volatility uncorrelated returns. This chapter considered investors' expectations, while avoiding the trap of thinking of the short book as an afterthought of the more fun long book. If those problem stocks are removed from your field of vision, they will not be on your mind and this will eliminate temptation.

Once you have distilled your investment universe and understood what is expected of you by investors, it is time to pull the trigger. In the next chapters, we will put everything together, and see how this can be done in practice.