Long / short equity

Long/short equity is an investment strategy generally associated with hedge funds. It involves buying long equities that are expected to increase in value and selling short equities that are expected to decrease in value.

Overview

Typically equity long short investing is based on 'bottom up' fundamental analysis of the individual companies in which investments are made. There may also be 'top down' analysis of the risks and opportunities offered by industries, sectors, countries and the macroeconomic situation.

Long short covers a wide variety of strategies. There are generalists, and managers who focus on certain industries and sectors or certain regions. Managers may specialize in a kind of stock, for example value or growth, small or large. There are many trading styles, with frequent or dynamic traders and some longer term investors.

A fund manager typically attempts to reduce volatility by either diversifying Fact|date=June 2007 or hedging positions across individual regions, industries, sectors and market capitalization bands and hedging against un-diversifiable risk such as market risk. In addition to being required of the portfolio as a whole, neutrality may in addition be required for individual regions, industries, sectors and market capitalization bands.

There is wide variation in the degree to which managers prioritize seeking high returns (which may involve concentrated and leveraged portfolios) and seeking low volatility (which involves more diversification and hedging).

Equitized strategy

This is in addition to market neutral strategy, as it adds a permanent stock index futures overlay which makes profit or losses depending on the movement of the market. Your portfolio then has a full equity market exposure.

Hedging example

A hedge fund might sell short one automobile industry stock, while buying another -- for example short $1 million of DaimlerChrysler, long $1 million of Ford. With this position, any event that causes all auto industry stocks to fall will cause a profit on the DaimlerChrysler position and a matching loss on the Ford position. Similarly, events that cause both stocks to rise (for example a rise in the market as a whole) will have little or no effect on the position.

Presumably the hedge fund has sold DaimlerChrysler and bought Ford because the manager expects Ford to perform better. If the manager is correct, the fund should profit irrespective of market and sector moves.

Market neutral strategies

Market neutral strategies can be seen as the limiting case of equity long short, in which the long and short portfolios of the fund are balanced with great care so that a very high degree of hedging is achieved.

Strictly, "Market neutrality" just refers to hedging out market risk, which can be managed through the use of derivatives such as futures on market indexes. However, market neutral funds usually seek to hedge against most or all predictable risk exposures. As a result they are among the least volatile hedge fundsFact|date=June 2007.

Problems with Long/Short Equity

There are many difficulties with managing long/short funds. These include the difficulties of estimating and hedging the risks to which a porfolio is exposed, and the requirement to manage unsuccessful short positions in an active manner. Short positions that are losing money grow to become an increasingly large part of the portfolio, and their price can increase without limit.

However, the major difficulty is that to make money the hedge fund must successfully predict which stocks will perform better. Most investors grossly underestimate the difficulty of this task. It requires making intelligent use of the available information, but this is not enough -- it also requires making better use of the available information than large numbers of capable investors.

There are significant difficulties in achieving this sort of equity, which is why only institutional traders and hedge funds engage in them. Primarily, there is the cost of setting the trades up, of balancing the portfolio, and picking the index stocks. There are also additional costs in the 'two for one' arrangement of L/S E, since basically a manager is gambling the market is unstable. If the market remains very stable, small fluctuations may ruin him -- his long position may sink and his short position may rise, leaving him with nothing. [http://72.14.209.104/search?q=cache:4cCy2xOAvccJ:www.ssi-invest.com/WhitePaper/Mercer.PDF+Long/short+equity&hl=en&gl=us&ct=clnk&cd=3 403 Forbidden ] ]

References