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Understanding Long Short Equity

While hedge funds implement a number of equity-based investment strategies, the long/short equity strategy has proved to be one of the most durable over the past twenty years. Indeed, the investment strategy gained steam in the mid-1990s on the back of a bull equity market; although assets allocated to the strategy declined after the tech bubble burst in 2000, it has remained viable due to the flexibility it affords managers to reallocate assets in volatile markets.

The main advantage underpinning the long/short equity strategy is versatility: Hedge fund managers typically hold a portfolio of equities with a "long" position along with a portfolio of equities with a "short" position. The strategy's versatility allows a hedge fund to decouple bets on perceived pricing asymmetries in the market that might benefit a class of equities over the long-term and punish others over the short-term. There is no standard investment allocation among long/short equity managers: Funds usually diversify and change investments based on diverging trends in sectors or geographical markets. Due to the active nature of manager choice in driving returns, long/short equity funds typically experience higher "alpha" returns compared to other hedge fund investment strategies: alpha refers to returns above the market (or beta) returns on a risk adjusted basis attributed to a manager's skill in picking investments.

A long/short hedge fund can choose from three different positions in order to drive returns. First, the hedge fund can adopt a net short position in which the short position (measured in percentage terms) is greater than the long position. While a net short position introduces substantial risk, it can also offer substantial returns by betting against unsustainable trends in the market. David Einhorn, the main principal of Greenlight Capital, successfully used a net short position during the market turmoil of 2008-2009 to profit off of overvalued financial stocks. Second, the hedge fund can adopt a net long position: most long/short hedge funds maintain a net long bias in order to benefit from the equity market's historical trend to move high, although this trend has noticeably weakened in recent years. Finally, the hedge fund can maintain a market "neutral" exposure. This position entails holding a 50% long position and 50% short position in equity and equity-based derivative instruments: The offsetting positions can be in a certain sector (such as automobiles) or can reflect an allocation in the equity market as a whole.

While the short/long strategy gives the hedge fund manager flexibility in implementing different investment strategies, there are a number of limitations. The main limitations and risks are associated with managing short positions. Short positions can be divided into two different types (traditional versus "naked"), and they open up investors to greater levels or risk particularly if an investor must cover a short through purchasing stock. Another limitation is the difficulty in estimating the risk profile of short/long equity investments. Due to the diversity of investments in a long/short fund, including the use of hedging instruments, it's difficult to know if a market "neutral" fund is truly neutral or the ultimate exposure of a short in a volatile market.

With these caveats in mind, the long/short equity investment strategy is one of the most emulated in the hedge fund space. In addition to the flexibility it offers managers to change bets and rotate in and out of investments, it also allows more sophisticated investment strategies to take advantage of simultaneous asymmetries in the market.

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