If George Costanza Were a Hedge Fund Manager

James White, Victor Haghani∗

Elm Partners
January 2019

It’s a bit of an over-simplification (but not by much) to say that investing is about predicting how things will
turn out in the future, and placing your bets accordingly.1 If your prediction is right, you generally expect your bets
to make money and you are happy. But there are some relatively common types of investing strategies in which your
predictions about future price moves can be correct, but you lose money anyway.

Here’s an example: let’s say at the start of 2007 you have $100 of capital, and you use it to put on a trade of
long $100 of Goldman Sachs (GS) and short $100 of Morgan Stanley (MS). You do this because you expect GS to
outperform MS. Each month, you re-balance your trade so that both the long and short leg are equal to your current
total capital, which has grown or shrunk from $100 based on the relative moves of the stocks. Rebalancing like this
is not the only way to hold a long-short position, but it’s rightly popular as it significantly reduces the chance of
losing more than 100% of your starting capital.

So, how did you do? The total return of GS to the end of 2018 is a loss of 3%, but MS is down 29%. You were
right, GS outperformed. You made a good prediction of the future. But how much money did you make? Maybe a
profit of $26, arising from the 26% by which GS outperformed MS?

Unfortunately, a $26 profit isn’t the right answer. It’s not even close. The actual outcome is you’d have lost $24!2
Before trying to explain, we want to tell you that there’s nothing unusual about these two stocks and the paths they
took.3 The crux of the explanation is that being short a stock is not the opposite of being long it. Imagine you
open a brokerage account and put in $100 which you use to buy a stock. This is going to sound really obvious, but
at all points in time in the future, the current value of your brokerage account will be equal to the current value
of the stock. Let’s compare that with being short a stock: you again open a brokerage account, put in $100, and
go short $100 of stock. If the stock goes up by 10%, now the value of your brokerage account is $90, as you have
an unrealized loss of $10 on your short, but the value of your stock short is $110. Not good, and it’s not advisable
to simply do nothing. If you don’t cover at least $20 of your short to bring it in line with your capital, you can
find yourself running a heightened risk that you could lose your full $100 and the broker will cover your short for you.4

Keeping our focus on the short stock trade, let’s assume you initially shorted the stock at a price of $100, and
then the price goes up or down each month by $10, fluctuating around $100, and at the end of the year, it’s right
back to $100 where it started. Here’s where there is a big difference between being long that stock or short it. If
you were long the stock, the value of your account would be the $100 you started with. But if you were short, and
if your policy is to equalize the value of your short position to the value of your account once a month, you’d lose
about 1% per month from rebalancing that short position.5 It’s tough to make money being short a stock: you don’t
∗ Victor is the founder and CIO of Elm Partners, and James is Elm’s CEO. This not is not an offer or solicitation to invest. Past

returns are not indicative of future performance. Thank you to Jeff Rosenbluth, Chi-fu Huang, Larry Hilibrand, Andy Morton,
Vlad Ragulin, Vladimir Piterbarg, Derek Smith, and Garth Friesen for their thoughtful help with this note.
1 We are devotees of thinking about investing in terms of probability distributions, scaling functions, and risk-adjusted returns, but

for this note we’ll put that aside for simplicity.

2 Ignoring transactions costs, borrow fees, and interest earned on your capital.
3 You’d get these same results if we simulated a random walk for stocks A and B, such that one was down 3% and one down 29% over

the horizon, and they had annual standard deviations of returns of 31% and 37%, and a correlation of 0.75 as GS and MS did over the
period. We also confirmed this result more generally in the pool of the roughly 400 stocks that were continuously in the S&P500 from
2007 to through 2018.
4 The situation with levered longs is essentially identical. The similarities between holding a short and holding a levered long position

run deep.
5 And all that rebalancing generates a lot of turnover, which often involves other costs and frictions. For example, in our illustrative

GS versus MS trade, turnover averaged $245 per year on a starting trade size of $100.

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Electronic copy available at: https://ssrn.com/abstract=3315624
just need to be right, you need to be very right!6

Now here’s where things get even more interesting, and where George Costanza makes his appearance. If you
were long GS and short MS, we’ve seen that you lost money. But what if you had the GS-MS trade the other way
around, long MS and short GS? You’d lose even more money, 34% of your starting capital to be precise! What kind
of devilish trading strategy loses money both ways around? Well, it’s the kind of trade that George Costanza would
probably have chosen, if the producers of Seinfeld had him working for a NY hedge fund instead of the NY Yankees.

It always hurts to lose money, but it really stings when it happens despite our investment thesis proving correct,
as in the case of the GS versus MS trade we started off with. In the Seinfeld episode titled “The Opposite,” George
complains to Jerry that every decision that he has ever made has been wrong, and that his life is the exact opposite
of what it should be. Jerry, who clearly is unaware of the nature of long-short trades, tells George “if every instinct
you have is wrong, then the opposite would have to be right.” Wouldn’t it have been just perfect if George, true to
character, proved Jerry wrong by finding an investment that would lose money both ways around? That’s why we’re
pretty sure that if George Costanza were a hedge fund manager, long-short would be his trade.

6 We hope someone will pass this note along to Elon Musk, to help him find some sympathy for Tesla short-sellers, or at least to

help him feel better to know how poorly many Tesla short-sellers have been doing given Tesla’s (and Musk’s) high (44%) volatility. Even
if you shorted $1mm of Tesla stock at its all-time high price of $385 per share on September 18, 2017, by the end of 2018 you’d have
lost 10% of your capital, even though the stock finished the year trading at $333, down 13.5% from that all time high. See the third
bulletpoint in Appendix 1 for an explanation of this 23.5% difference.

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Electronic copy available at: https://ssrn.com/abstract=3315624
Appendix 1: A More Formal Treatment
The question we want to answer more formally is what is the expected profit/loss on a long-short trade with the
following characteristics:

a. Long stock A and short stock B, with prices at time t denoted by At and Bt and share quantities denoted by
αt and βt
b. At and Bt both follow Geometric Brownian Motion with means µA , µB , volatilities σA , σB , and correlation ρ.
i.e. dA dBt
At = µA dt + σA dZA (t) and Bt = µB dt + σB dZB (t)
t

Rt
c. Capital at time t of Ct = C0 + 0
(αt dAt + βt dBt )

d. The trade is continuously rebalanced to keep both the long and short exposures equal to total capital, i.e.
αt At = Ct = −βt Bt ∀ t
e. The realized return on A and B at horizon T is equal to their expected return, i.e. rˆA , E[ln(AT ) − ln(A0 )] =
ln(AT ) − ln(A0 ). This implies µA = rˆA + 21 σA
2
, and likewise for µB

We want to compute E[CT |AT = A0 erˆA T , BT = B0 erˆB T ]. Combining (b)-(e) above gives the capital dynamics:

dCt dAt dBt

= − (1)
Ct At Bt
1 2 1 2
= (rˆA − rˆB + σA − σB )dt + σA dZA (t) − σB dZB (t) (2)
2 2
Setting Z ∗ = σA ZA − σB ZB and applying some Itô calculus then gives us:
2 ∗
Ct = C0 e(rˆA −rˆB −σB +ρσA σB )t+Z (t)
(3)
If we were looking for the unconditional expectation of CT we could now calculate it, but as we’re looking for the
conditional expectation, (e) above implies that ZA (T ) = ZB (T ) = 0, so we end up with:
2
E[CT |AT = A0 erˆA T , BT = B0 erˆB T ] = C0 e(rˆA −rˆB −σB +ρσA σB )T (4)
A few things to note:
2
• The trade being profitable requires rˆA − rˆB > σB − ρσA σB .
• If σA = σB , A needs to outperform B by more than half the variance of the pnl.
• For a standalone short trade, we can set σA = 0, and we see that to make money on the trade, the short needs
2
to go down by more σB .
• If σB < ρσA , the trade can still be profitable even if A has a lower expected and realized return than B.
• For the GS/MS trade described in the body, (4) ties very closely to the outcomes we reported using monthly
rebalancing for the trade, both ways around.

3
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Appendix 2: Historical Price Series of GS and MS, and Calculation
of Long-Short Strategy Returns with Monthly Rebalancing (data from
Yahoo finance)

4
Electronic copy available at: https://ssrn.com/abstract=3315624