It’s that time of year again! Pumpkin spice, snow, and if you’re lucky, eggnog. Preferably eggnog spiked with a lot of alcohol. Know what else it’s time for? Protecting your P&L!
Working at a hedge fund is a very interesting role. When I was an engineer, I would work on various projects. Sometimes the projects were related, but in many cases one had nothing to do with the other. It was always important to stay focused for the life of project but if there ever was a mistake, you could always go back and fix it. This is nothing like working at a hedge fund.
I like to tell people I have the easiest job in the world because I only have one responsibility. Make money. It’s that simple. If I make money, I’m doing a good job. If I’m not, then I need to reconsider whether this is the right job for me. Or maybe somebody else will make that decision for me.
My comp is based on how much money I generate in a calendar year. It’s strange because previously, I’ve never had a job where I could be awesome in the first 10 months, then lose everything in the final two. When you write software, you don’t lose all the code you wrote in the year because you created a bug in the last month. But this happens all too often in the hedge fund world. You can be up $50 million, then lose all of that in the last two months because of bad bets or unlucky events. I know guys that had their P&L cut in half on December 31st, all because some stupid company decided to announce something stupid on the last day of the year. It has never personally happened to me, but I have total empathy for these people.
A large portion of my comp comes from how much P&L I generate. So this is real money we’re talking about. And it’s real money for a lot of people that work in this industry. This is why when we get late into the year, people like me are doing everything we can to protect our profits. Here are some of the things I do to protect my P&L.
Moving to All Cash to Protect P&L
This seems like a obvious decision. So obvious that nobody will let you do it. I would love to go all-cash if I’m up a lot. That way, I can ensure a decent payout at the end of the year. But the higher ups hate this. Not only is it very disruptive to the markets. Can you imagine having all these institutional investors sell stock at the end of the year? Think of all the selling pressure! It’s also bad for our investors because we’re paid to deploy capital, and going to all-cash doesn’t do that. So moving to all cash isn’t possible, but they can’t really complain when you sell down positions and say you don’t have any new ideas to add to the book.
Unwinding Risky Bets
When you take big risks, you expect big returns. If I’m up a decent amount and going into the end of the year, I’m not taking big risks. There are a few stocks that I’ve been looking at that are up massively this year. Valuations are at all-time highs, they’ve had big moves, and I think fundamentals could be weak for next year. I won’t short these stocks this year. The last thing I need is to put money in a stock that’s going to lose money that should be going into my pocket. No, I’m going to wait until January before I short these stocks. That way, I’ll have a brand new P&L to work with and if I’m wrong, I’ll have 12 months to make it up.
This is why momentum works at the end of the year. Momentum will break at some point in time, but nobody wants to risk their P&L to prove it.
I’ve never personally done this, but I hear it happens, especially with mutual funds. Institutional investors are required to file Form 13F’s every quarter to disclose their holdings. I personally don’t care what it says I own, but I hear it’s more important for mutual funds because retail investors buy mutual funds and you don’t want everybody to know you have a large ownership in a turd. So mutual funds will sell down those underperforming stocks before the end of the year to avoid any embarrassment. I personally think this is ridiculous but I don’t work at a mutual fund. In my opinion, all that matters is performance. If somebody owns a bunch of turd stocks but has also somehow managed to outperform the benchmark, more power to her.
Taking Advantage of De-Risking
At the end of the year, I’m de-risking like many other institutional investors to protect P&L. As a retail investor, you don’t have the same concerns as me. I need to protect P&L to ensure a high payout this year. You get paid as soon as you sell your stock. So how can you profit from all this?
Buying the Laggards
This is a well known strategy that works very often in the new year. I don’t want to risk owning a laggard at the end of the year, but I’m happy owning it at the beginning of next year because I’ll have 12 months to make up any losses. As a retail investor, you’re indifferent to buying in December or January. Since institutional investors like me are going to buy in January, you should get ahead of the curve and buy in December! This doesn’t work every year, but it works more often than not. This is another way you can take advantage of hedge fund short-term thinking!