Equity Long-Short Defined
Understanding the financial and investment market requires some knowledge of basic principles of buying and selling securities. There are a number of different types of bonds, stocks, debts and claims that can be added and subtracted from an investor’s portfolio to balance it with risk and reward. Similarly, there are a number of positions that investors themselves can take to reflect their intent and interest in the investment market.
Understanding the Long-Short Equity Strategy
Long/short equity is the oldest known hedge fund investment strategy in the corporate world. The first Long/short equity fund was created by Alfred Winslow Jones back in 1949 with the goal 1) to manage market risk with short sales of a long equity position portfolio, and 2) to achieve effective and profitable portfolio performance through strong security allocation on both the sides (long and short.) The purpose of the fund was to create a portfolio that has lower market risk and did well in both upward and downward markets.
Long and Short Equity is a strategy adopted by investors when dealing with securities on the trading floor. What is this strategy and how does it work to benefit the trader, are some questions that can be answered once the reader understands the meaning of ‘long’ and ‘short’ in this context.
What Are Long and Short Positions?
Long and short are two opposite positions that investors can take while dealing with securities. The Long Position means that an investor:
- •Will buy stocks, currencies or commodities with the speculation that their value will increase.
- •Will buy contracts/options to trade on the floor.
While a Short Position means that an investor:
- •Will sell stocks, commodities and currencies with the speculation that their value will drop.
- •Will sell contracts and options to other traders.
In short, when an investor sells, he is said to be in a short position and when he buys stock in the same market, he is said have a long position (opposite of short.)
The Long-Short Equity Strategy
With these two positions, an investor then plans how many securities to buy or sell in the market. The Long-Short Equity Strategy is quite famous among institutional investors like Hedge Funds because it allows them to balance portfolios with some risk and reward.
According to this strategy, investors take a long position for stocks that are expected to rise in value and a short position for those that will eventually see a dip in face value. In a way, holding securities in this way minimizes the chances of loss and exposure to the market because, in both positions, an intelligent investor is making a profit, from the decline in value of the short and the increase in value of the long.
In other words, a long-short equity strategy is an investing strategy, primarily used by the hedge fund investors, that focuses on inventing in long positions (in stocks) that are likely to increase in value over time and short positions that are likely to decrease in value over time.
Being institutional, Hedge Funds usually have a lot of experience and financial backing to take long and short positions on speculative stock. Sophisticated tools used to predict outcomes help these investors in coming out victorious. Nonetheless, there are some important concepts to keep in mind if investors want this strategy to work for them. These include:
- •Dollar Equality- A core principle of market neutrality is Dollar Equality. This means that the dollar value of investments in long and short positions should be the same. Since the long-short strategy minimizes market exposure and creates a win-win situation, having the same worth of both securities helps an investor realize profits easily.
- •Net basis- The long-short strategy works on a net basis. For instance, if an investor records a profit from his long position and a loss from the short position, his realized gain is the net of both results. The net basis is the reason two positions are taken in this strategy.
- •Investing in different sectors-A long standing rule of the investment world is that securities in one industry/sector move together. So if the stock for Ford is expected to go up, so will that of Toyota. Since there is a certain level of unison between stocks of the same market, the long-short strategy works best when two stocks from different industries are picked.
A good example to explain these conditions will be that of a Hedge Fund deciding on its investments when interest rates are rising in the market. Taking the Long-Short Equity approach, the Hedge Fund will make necessary analysis and decide to take a short position on securities that are sensitive to interest, namely utilities.
On the other hand, it will take a long position, i.e. buy securities that are insensitive to interest rates, such as those in the healthcare sector. With this carefully thought-out investment plan, the Long-Short Equity Strategy is bound to work for experienced and large scale investors.
Long/Short Equity Hedge Funds and Investment Portfolios
Long/short equity hedge funds are considered far more effective than the traditional equity funds. According to a research survey, assets and securities run by long/short equity hedge funds programs have seen substantial growth in the past decade (around 20% annually.) This shows the capability of long/short equity managers that were able to generate alpha through strong stock selection.