Long/short equity strategy allows hedge fund managers to short equities by taking advantage of stock selection to generate optimal risk-adjusted returns. In fact, a long/short equity strategy separates the stock risk from the market risk, thereby shifting the investment risk to the fund manager. Long/short equity strategy is one of the most broadly used hedge fund strategies with more than $300 billion in hedge fund assets.
The long/short equity strategy combines two investment strategies: taking long positions in stocks that are expected to rise and taking short positions in stocks that are expected to decline. In the long position, the hedge fund manager owns the underlying security and expects that the stock price will rise before maturity (market price > strike price); in the short position, he borrows the underlying security and expects that the stock price will decline before maturity (market price < strike price). Using both strategies with a long/short equity strategy, hedge fund managers leverage the market risk and minimize market exposure.
A Quick Example
A hedge fund manager believes that the stock price of Accenture will rise, and the stock price of IBM will decline over the next 30 days. He takes a long position in Accenture at a strike price of $120, and a short position in IBM at a strike price of $1 45. If Accenture rises at $125 (market price > strike price), the hedge fund manager will buy the underlying security at $120 and will sell it in the open market at $125, thereby realizing a profit of $5 per share. If IBM drops to $135 (market price < strike price), he will sell the underlying security at $145 and will buy it in the open market at $135, thereby realizing a profit of $10 per share.
When using a long/short equity strategy, hedge fund managers look for overvalued and undervalued stocks. Most of the times, they take opposite positions of equal size, 50% long – 50% short (market neutral strategy), thus minimizing risk as the gains of one position trade-off for the losses in the other. Other times, they are biased in their expectation, thus taking uneven positions and allocating their exposure by 120% long – 20% short or 130% long – 30% short. In any case, the long/short equity strategy has an infinite upside potential, which is the profit on the spread between the long and the short position.
The long/short equity strategy has historically returned equity-like profits by capitalizing on lower volatility and stock selection. Hedge fund managers have the freedom to select underlying securities they believe will meet their long and short positions while remaining attractive investments for their institutional clients. In fact, the long/short equity strategy is often used as a replacement of the traditional stock investment and portfolio allocation. Furthermore, with the variants of neutral market strategy and paired trade, the long/short equity capitalizes on overvalued securities and, as the market keeps correcting itself, the payoff is high since the prices of the two similar stocks, which trade in the same sector, are converging.
Using the long/short equity strategy, hedge fund managers determine the market exposure by adjusting their short position in stocks that can leverage market risk. However, as with any other hedge fund strategy, there is the risk of a hedge fund with a low liquidity, which cannot trade shares easily. A hedge fund’s net exposure, i.e. the result of subtracting the short positions from the long positions, is generally an indication of a hedge fund manager’s risk appetite: the higher the net exposure, the higher the risk undertaken. Since the long/short equity is an actively managed strategy, there is always the risk of misjudgement with respect to the relative performance of the underlying securities as well as high fees. Finally, there is always the market risk. If the market declines sharply from an unforeseen event, the losses on the long positions will be significantly higher than those of the short positions.
The Bottom Line
Long/short equity strategy is a diversified hedge fund strategy with infinite upside potential. Due to its diversity, hedge fund managers should be prudent in the stock selection to increase their returns while minimizing risk. Given the sustained growth of the equity markets, the long/short equity strategy is expected to remain one of the most broadly used hedge fund strategies available to investors.