Long-Short Equity — Definition, Mechanism, and Examples
Long-short equity denotes a type of investing strategy where investors take long positions in stocks expected to appreciate and short positions in stocks expected to decline. Its primary goal is to limit market exposure while generating profits from the long-positioned stock gains and the short-positioned price declines. Many hedge funds employ a market-neutral strategy where they equalize the dollar amount of both long and short positions.
The mechanism behind long-short equity is to capitalize on opportunities from both the expected upward and downward price moves. Investors recognize and take long positions in stocks deemed as relatively underpriced and sell short stocks considered overpriced. Hedge funds tend to employ a long-short equity strategy with a long bias — for example, 130/30, which means the long exposure is 130 percent and short exposure is 30 percent. The opposite, employing a short bias in a long-short strategy, is relatively rare. The reason is, profitable short ideas have proven harder to identify than long ones.
There are several ways to classify long-short equity strategies. These include market geography (emerging markets, advanced economies, US), economic sector (energy, healthcare, technology), or investment philosophy (based on value or growth). For example, a global equity growth fund qualifies as a long-short equity strategy with a broader scope, while an emerging markets healthcare fund exemplifies a narrower one.
It is also noteworthy to differentiate between a long-short equity fund and an equity market neutral (EMN) fund. The latter seeks to capitalize on the long and short differences in the prices of closely related stocks sharing similar characteristics. An EMN strategy strives to keep the total value of their long and short holdings almost equal and thus, minimize the overall risk. To achieve this, EMN funds must rebalance as market trends emerge and become established.
So, while other long-short hedge funds derive profits by following market trends and often leverage investments to increase their profitable positions, EMN funds deliberately liquidate profitable positions and shift that capital to the opposite position. At the next turn of the market, EMN funds again shift funds, adding more to the suffering part of the portfolio.
Hedge funds with an equity market neutral strategy usually target institutional investors who are looking for a hedge fund that can outperform bonds but lacks the higher risk and rewards associated with more aggressive funds.
The so-called “pair trade” is among the most popular long-short equity strategy. It entails balancing the long and short positions of different stocks within a specific sector.
For example, an investor in the technology sector may take a long position in one tech company and balance it with a short position in another. If the first company’s shares cost $33 each and they buy 1,000 of them, and the second company is trading at $22, they must short 1,500 shares of the second company to equalize the dollar amounts of the long and short positions of this pair trade.
In the ideal case of this long-short strategy, the first company’s shares would appreciate, and those of the second would decline. If the first company’s shares go up to $35 and those of the second drop to $21, the overall profit would be $3,500. However, the second company’s share price may also rise, a not unlikely event because stock prices in a specific sector are usually driven by the same forces. If the price increased to $23, this long-short equity strategy would still generate a profit of $500.
Long-short strategists have found a way to circumvent this tendency for harmonized share price fluctuations within a specific sector by using different sectors for the long and short positions. For example, if interest rates are on the rise, a plausible long-short strategy would be going short on interest-sensitive sectors like utilities and long on defensive sectors like healthcare.
