Shorting Dead Ends

Shorting mathematically guaranteed zeros.

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The holy grail for most hedge funds is something called ‘non-correlated sources of alpha’.

In simple terms, something that will outperform regardless of the broad market movements.

Many value investors, myself included, see the secular opportunity in the commodity sector and yet it is my contention that very few will actually realise profits from the theme.

The obstacles between a great thesis and the realisation of profits, particularly in this sector include, but are not limited to: volatility, contango + its associated negative roll yield (explained below), the inherent correlation with the overall market leading to a broad market sell-off crushing the prices of this sector (liberation day) even though the fundamental performance of the sector is relatively unchanged etc.

Take a moment to think about the usual suspects that wreck investor performance, particularly, yet not exclusively as it relates to commodities:

• Contango and i negative roll yield (present prices being lower than anticipated futures pricing and hence the front month position is sold at a loss as it decays faster than those futures priced further out and having to buy those same positions at higher costs - the difference is known as a ‘negative roll yield’ )

• Management fees - another form of negative roll yield if you think about it.

• Leverage, ladies and liquor. The latter two can be detrimental to be sure, but they both pale in comparison to the former.

Today’s piece gives an overview on a strategy that has been highly successful for me and allows an investor to directly profit from the aforementioned issues rather than being taken advantage of (with the exception of ladies and liquor which are far more complicated than quantitative mathematics).

The strategy can be added as a small part of a value portfolio or could potentially be a portfolio in and of itself.

I’m talking about identifying products that exist in the market which have a mathematical certainty of going to zero and shorting them.

You may think this cannot exist because the market is efficient and would not allow for such a thing. Over a sufficient timeframe you would be correct - and that’s exactly what I’m counting on.

Let’s delve into the mathematics..