What is long-short equity?

Long-short equity is the investment strategy in which the investor takes a long position in the stocks whose prices are expected to go up and a short position in the stocks whose prices are expected to decline. The aim of the long-short equity is to minimise market exposure as revenue is generated from the short position in declining stocks and long position in the gaining stocks. The strategy should be made profitable on net basis, in most cases.

The long-short equity is popular among the hedge funds who use a market neutral strategy, that is, the amount on both long and short positions is same.

 

Summary

• Long-short equity is the investment strategy in which the investor takes a long position in the stocks whose prices are expected to go up and a short position in the stocks whose prices are expected to decline.
• The aim of the long-short equity is to minimise market exposure as revenue is generated from the short position in declining stocks and long position in the gaining stocks.
• The long-short equity is popular among the hedge funds who use a market neutral strategy, that is, the amount on both long and short position is same.

Frequently Asked Questions (FAQs)

What is the working of long-short equity?

Long-short equity strategy generates revenue by exploiting both potential upward and downward movements in the prices of the securities in the financial market. The strategy involves identification of the overpriced and under-priced financial assets. Afterward, the investor takes long position in the under-priced stocks and short position in the overpriced stocks. For instance, consider an investor taking a long position in the under-priced stocks. When the prices of the stocks reach their true value (price which includes all the market information), then investor will sell the holdings and make profit from the difference between under-price and the actual price.  

The long bias is combined with the long-short equity strategy by the hedge funds, that is, the percentage of long exposure is higher than the short exposure as it uncovers vast opportunity of profitability. The utilisation of long bias is more than the short bias by the hedge funds as historical data indicated that it is difficult to make a profit with short ideas in comparison to the long ideas.

Differentiation can be created between the long-short equity in several ways such as sectors, industries, market geography, investment objectives, to name a few.

Image source: © Michalsuszycki | Megapixl.com

Why should an investor take long-short equity?

The long-short equity strategy extends three main advantages to the investor.

Systematic risk is mitigated - Long-short equity provides insulation against the market exposure, therefore, investors can utilise long-short equity strategy to safeguard themselves. When the value of the market increases as a whole, then the long positions in the portfolio will make a profit for the investor. On other hand, when the value of the market declines, then the stocks in the portfolio with a short position will generate profit for the investor.            

Maximisation of spread – Long-short equity position serves the purpose of maximising the spread. Spread is the difference between the short and the long position undertaken by the investor in the stock market. Investing in this way allows the investor to make profit from losses and gains simultaneously, and therefore the investor can make more profit than by making an investment in single stock only.

Market neutral position - Creation of the market neutral apposition in the market is not the major goal of long-short equity. In this strategy, the investor makes the same amount of investment in the long and short positions. Through this type of investment, the investor aims at protecting the portfolio from the market risk, and the amount of losses is equal to the amount of profit, either make an upward move or downward move.

What are the key points in long-short equity?

The due diligence which is required for long-short equity is more complicated than the long-only position. A manager needs to consider the following points while selecting the securities and position:

Size of the position should be assessed carefully – In case the investor raises too many assets, then it becomes difficult to make use of the assets to their full potential without affecting the strategy’s return potential.

Usage of the short portfolio – In the long-short equity, some strategies utilise the short side as alphas. In these cases, the managers should show that value can be added by shorting stocks. Some managers make use of the short position as an equity market hedge. In this case, the value should be added to the portfolio by adjusting the net exposure to equities through hedges.

Process of taking a short position in the stocks – The process of shorting stocks requires managers’ ability to research stocks and screen the process. The stock shorting process might be new for few managers. Therefore, it is crucial to assess the investment team’s experience in the context of the stock shorting process and the investment team should undertake a systematic process for locating stock to short.

A long position in the portfolio – The process of identification of stock for shorting is important and similarly the process of identifying stock for a long position plays an important role. The investment team and manager need to make sure that the long positions add value to the portfolio.

What is the difference between equity market neutral and long-short equity?

The equity market neutral strategy takes a short and long position in similar stocks and attempts to take advantage of the differences in the stock prices. This is the major differentiating aspect between the two.

In the equity market neutral strategy, the value of the short and long position is generally the same as the aim is to avoid the risk. In order to maintain the equivalence in the long and short positions, the fund managers need to rebalance as per the changing market trends.

The long-short equity generates earnings as per the market trends and amplifies them too. On another hand, equity market neutrality aims at restricting returns and increasing the amount held in the opposite position. Thus, when the market turns, these funds skew towards low performing portfolio.