Isolating the Impact of Shorts In a 130 30 Portfolio

In a recent post, Simulating an Ideal 130 – 30 Portfolio we looked at what a skilled stock picker working within the Nasdaq 100 might be able to achieve. We used Portfolio Workstation to model a hypothetical portfolio for this stock picker and compared it against a benchmark strategy of buy and hold QQQ. The main idea was that the stock picker would allocate 90% to long picks, negative 30% to short picks, and 40% to treasuries, meeting the criteria for both the 130 – 30 hedging structure, and the 60 / 40 net allocation to stocks and bonds.

In this post, we will isolate the impact of the short stock picks by substituting the 90% allocation to long stock picks with a 90% allocation to QQQ in the 130 – 30 portfolio from before. As a reminder, the short picks used in this portfolio were selected with the benefit of hindsight by assuming that a skilled stock picker would be able to pick short positions that would have returns similar to the top of the fourth quartile of performance over the period under study, January 1, 2007 to present. We sorted the Nasdaq 100 and chose the stocks at positions 76 – 80. Reality would be quite different, since nobody would probably sit in the same short positions for 8 years, and the Nasdaq 100 isn’t the best index to be picking shorts in. By looking past these oversimplifications, we can develop an intuition for how different portfolio building strategies might play out in the future if carefully implemented.

Here is the new 130 – 30 portfolio, with the only stock picks appearing on the short side:

Portfolio 130 30 short picks only

These results are considerably worse than when our stock picker was also skillfully choosing long positions. It makes sense though, because this portfolio implies that any stock picks would be average, achieving index-like returns.

This time, our benchmark will be a 60 / 40 portfolio composed of QQQ and TLT. Here is the chart and stats for the benchmark:

Portfolio 60 40 benchmark

Your eyes do not deceive you! It is almost an exact match. One takeaway is that maintaining short positions over long periods of time is difficult. The short position picks used here are from the bottom quartile for returns over a period of about 8 years. Over these 8 years, the worst stocks have already dropped out of the index and wouldn’t have been identified by our sort (a hindsight bias). A successful short stock picker can’t just sit short in mediocre stocks and outperform, they will need to have at least some short positions in stocks that are falling out of indexes, and without getting caught in short squeezes or takeovers.

At the wikipedia page for the Nasdaq 100, we counted 72 companies that were replaced in the Nasdaq 100 since 2008, for various reasons, but not all of them bad. This high turnover implies a fertile ground for stock pickers.

In conclusion, we find it encouraging that given the narrow parameters of this study, it seems clear that a highly skilled shorting expert could produce much better results than the compelling hypothetical scenario we’ve shown here, and with no effort given to picking long positions if using index ETF’s as a substitute.

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