Long/short equity is a hedge fund strategy that consists of taking long and short positions in individual stocks. The aim of a long/short equity fund is to buy undervalued stocks, and to sell overvalued stocks. The stocks in which the fund takes a long position are therefore expected to increase in value, while the stocks the fund is short are expected to decrease. When this scenario takes place, the stocks previously bought can be sold at a higher price, while the stocks shorted can be bought back at lower prices.
However, a long/short equity fund can also make a profit even when both the long and short positions increase or decrease in value at the same time. As long as the stocks bought outperform stock stocks sold short, meaning the stocks bought decline in value more slowly or increase in value more quickly than the stocks sold short, the strategy remains profitable. As such, long/short equity funds try to minimize the exposure to market fluctuations in general, and try to profit from changes in the spread between stocks.
To illustrate the above strategy, let’s consider the following numerical example.
Let’s consider a hedge fund manager that buys US$ 1 million in General Motors and sells short US$ 1 million in Ford. Both companies are carmakers. If there’s bad news about the carmaking sector, all carmaking companies will decline. However, the losses on the position in General Moters will be offset by the profits on the Ford position. Clearly, the returns on both positions cancel out. Thus, market risk is minimal in this case. At the same time, the fund manager will make money if stock of General Motors outperforms the stock of Ford.
130/30 strategy (long bias)
In the above example, if both stocks have the same market beta then the portfolio is market neutral. However, since stock markets tend to move up over time, a market neutral strategy might not necessarily be the best choice over long periods of time. That’s why most hedge funds tend to have a long bias, i.e. more exposure to long positions than short positions. A common strategy in this context is the so-called 130/30 strategy. In this case, the hedge fund manager will have 130% exposure in long-equity positions, and 30% exposure in short-equity positions. Of course, other percentages, e.g. 120/20 are also possible.
While the vast majority of long/short equity funds are market neutral or have a long bias, some funds aim to have a net short exposure. These funds follow a dedicated short-bias strategy.
Risks in long/short equity
While a long/short equity strategy sounds appealing, the difficulty lies in identifying undervalued and overvalued stocks. This requires superior stock picking skills. A second risk is so-called ‘beta mismatch‘. In the above example, we assumed that news on the carmaking sector influences both stocks equally. However, in practice betas need to be estimated and thus might be different. It is thus possible that our long positions lose more than our short positions when bad news is announced.