Understanding Hedge Fund Strategies: Equity Long / Short

singapore3-hedgethink Understanding Hedge Fund Strategies: Equity Long / Short

As part of our series looking at the strategies hedge funds commonly use to their advantage, let’s take a look now at one of the most popular strategies out there.

The equity long/short strategy is actually one of the building blocks of the original hedge fund movement, and can be traced back to the earliest days of these investment mechanisms. At their most essential, hedge funds are in the business of managing investment risk, and the long/short strategy is a very effective method of doing just that. Let’s see how it works.

Long/Short – the Basics

An equity long/short strategy is a method of investing that involves taking long positions in stocks that are expected to increase in value and short positions in stocks that are expected to decrease in value. The long/short equity strategy is popular with hedge funds, many of which employ a market-neutral strategy where the dollar amounts of the long and short positions are equal.

Long – Taking a long position in a stock basically means buying it: if the value of this stock increases in value then you will make money.

Short – Taking a short position, however, is a way of saying that you are borrowing a stock you don’t own, often from your broker, then selling it on in the hopes that it will decline in value. This enables you to buy it back at a lower price than you paid for it and return the borrowed shares.

Hedge funds then employ this strategy on a larger scale, as means of both profiting from a change in the difference, or spread, between two stocks, as well as minimizing their exposure to the market.

Profiting from long/short – essentially this strategy means buying an undervalued stock and shorting an overvalued stock. What hedge funds want to happen next is for the long position to increase in value, and the short position to decline in value. If this happens, and the positions are of equal size, the hedge fund will profit. But part of the reason that this strategy is so popular, and that it is viewed as a less risky investment method, is that it’s a strategy that works so long as the long position outperforms the short position – even if the long position actually declines in value.

An example

To understand better how this strategy works in real terms, let’s look at a simple example using the auto industry. A hedge fund may decide to sell short one automobile industry stock, while buying another, as the fund manager believes one stock will perform better than the other. For example, a fund could short $1 million of DaimlerChrysler, while going long $1 million of Ford.

In this example, any event that causes all auto industry stocks to fall will cause a profit on the DaimlerChrysler position while delivering a matching loss on the Ford position.

Equally, any event that causes both stocks to rise, such as a rise in the market as a whole, will have little or no effect on the position.

This means that the hedge fund should make a profit irrespective of market and sector moves if the fund manager has got things right and the Ford stock does outperform DaimlerChrysler. It also means that the investment risk is minimal.

Types of Long/Short Sub-Strategy:

Long/short is a type of equity hedge strategy and is one of the simplest strategies to get your head around. While many hedge funds employ this basic long/short method, they can use a variety of sub-strategies to achieve this.

Long/Short with leveraging – most funds will have positive exposure to the equity markets – say 70% of their funds are invested long while 30% are invested short. This means their net exposure is 70% – 30%, ie, 40%, while their gross exposure would be 100%. This indicates no leverage.

However, managers may wish to increase the fund’s long positions, to say 80%, while retaining the 30% short. This means an adjusted gross exposure of 80% + 30%, ie, 110%, which indicates leverage of 10%.

Long bias – this type of long/short strategy, for example, investing at a ‘130/30’ ratio of long to short (130% long and 30% short), or ‘120/20’, are known as long bias strategies. Fewer hedge funds employ a short bias over the longer term, as equity markets tend to move up over time.

Market Neutral – managers can minimize the exposure to the broad market and make their funds market neutral in a number of ways. Firstly they can invest equal amounts in long and short positions, eg, 50% long and 50% short means net exposure is 0% and gross exposure is 100%.

Secondly, they can ensure zero beta exposure. In this case, the fund manager would seek to make investments in both long and short positions so that the beta measure of the overall fund is as low as possible. In either of the market-neutral strategies, the fund manager’s intention is to remove any impact of market movements and rely solely on his or her ability to pick stocks.

Paired trades – this term is used when a fund employs the long/short strategy to buy and sell two related stocks, usually two stocks within the same region or industry. They do this as it may allow them to limit the risk to a specific subset of the market rather than just to the market in general.

Employing Long/Short Strategies

Long/short strategies are also popular because they can be employed across a range of different geographic regions, sectors and industries, such as technology, health, or financial. They can also be employed by funds across a range of investment styles, including value or quantitative.

Either of these long/short strategies can be used within a region, sector or industry, or can be applied to market-cap-specific stocks, etc. In the world of hedge funds, where everyone is trying to differentiate themselves, you will find that individual strategies have their unique nuances, but all of them use the same basic principles described here.

Problems

Just because the long/short strategy minimizes risk does not make it risk-free. There exist many difficulties when it comes to successfully managing long/short funds:

  • To turn a profit, the fund must be able to predict which stocks will perform better. This not only requires making intelligent use of research and the available information – it means making better use of the available information than large numbers of capable investors.
  • A fund must be able to realistically estimate and hedge the risks to which their portfolio is exposed.
  • A fund must also be able to manage unsuccessful short positions in a very active manner.
  • The fact that hedge funds are generally not as liquid as mutual funds can make it more difficult to sell shares in practical terms
  • Because of the skill involved in successfully managing a long/short fund, these hedge funds can have high fees
  • The risk of ‘beta mismatch’, which in very basic terms means that when the stock market declines sharply long positions can lose more than short positions.

The Benefits of Long/Short

  • Many investors concentrate on selecting winning strategies for long portfolios, but long/short strategies, and the implementation of selling short, frees investors up to take advantage of a far wider array of securities.
  • The successful management of a fully integrated portfolio of long and short positions can help to increase returns, even in difficult market conditions.