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Hedge Fund Strategy - Equity Long-Short

An equity long-short strategy is an investing strategy, used primarily by hedge funds, 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.

You may know that taking a long position in a stock simply means buying it: If the stock increases in value, you will make money. On the other hand, taking a short position in a stock means borrowing a stock you don’t own (usually from your broker), selling it, then hoping it declines in value, at which time you can buy it back at a lower price than you paid for it and return the borrowed shares.

Hedge funds using equity long-short strategies simply do this on a grander scale. At its most basic level, an equity long-short strategy consists of buying an undervalued stock and shorting an overvalued stock. Ideally, the long position will increase in value, and the short position will decline in value. If this happens, and the positions are of equal size, the hedge fund will benefit. That said, the strategy will work even if the long position declines in value, provided that the long position outperforms the short position. Thus, the goal of any equity long-short strategy is to minimize exposure to the market in general, and profit from a change in the difference, or spread, between two stocks.

That may sound complicated, so let’s look at a hypothetical example. Let’s say a hedge fund takes a $1 million long position in Pfizer and a $1 million short position in Wyeth, both large pharmaceutical companies. With these positions, any event that causes all pharmaceutical stocks to fall will lead to a loss on the Pfizer position and a profit on the Wyeth position. Similarly, an event that causes both stocks to rise will have little effect, since the positions balance each other out. So, the market risk is minimal. Why, then, would a portfolio manager take such a position? Because he or she thinks Pfizer will perform better than Wyeth.

Equity long-short strategies such as the one described, which hold equal dollar amounts of long and short positions, are called market neutral strategies. But not all equity long-short strategies are market neutral. Some hedge fund managers will maintain a long bias, as is the case with so-called “130/30” strategies. With these strategies, hedge funds have 130% exposure to long positions and 30% exposure to short positions. Other structures are also used, such as 120% long and 20% short. (Few hedge funds have a long-term short bias, since the equity markets tend to move up over time.)

Equity long-short managers can also be distinguished by the geographic market in which they invest, the sector in which they invest (financial, health care or technology, for example) or their investment style (value or quantitative, for example). Buying and selling two related stocks—for example, two stocks in the same region or industry—is called a “paired trade” model. It may limit risk to a specific subset of the market instead of the market in general.

Equity long-short strategies have been used by sophisticated investors, such as institutions, for years. They became increasingly popular among individual investors as traditional strategies struggled in the most recent bear market, highlighting the need for investors to consider expanding their portfolios into innovative financial solutions.
 
Equity long-short strategies are not without risks. These strategies have all the generic hedge fund risks: For example, hedge funds are typically not as liquid as mutual funds, meaning it is more difficult to sell shares; the strategies they use could lead to significant losses; and they can have high fees. Additionally, equity long-short strategies have some unique risks. The main one is that the portfolio manager must correctly predict the relative performance of two stocks, which can be difficult. Another risk results from what is referred to in the industry as “beta mismatch.” While this is more complicated that we can explain in detail here, essentially, it means that

when the stock market declines sharply, long positions could lose more than short positions.

In summary, equity long-short strategies may help increase returns in difficult market environments, but also involve some risk. As a result, investors considering these strategies may want to ensure that their hedge funds follow strict rules to evaluate market risks and find good investment opportunities.

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