The Long/Short Equity Strategy: A Comprehensive Guide
Welcome to our detailed exploration of one of the most commonly used strategies in the hedge fund world: the long/short equity strategy.
As you venture into the world of hedge fund investing, understanding this strategy can provide a significant advantage. This guide aims to break down complex financial jargon into simple, digestible information.
So, let's dive in!
Description of Long/Short Equity Strategy
Long/Short Equity is a type of investment strategy many hedge funds use. But what does it entail? Simply put, it involves buying (or 'going long') stocks that are expected to increase in value and selling (or 'short selling') stocks anticipated to decrease in value.
This strategy originated from balancing the portfolio and hedging against potential market downturns. The beauty of this strategy is that it can generate profits regardless of whether the market is bullish (up-trending) or bearish (down-trending).
How the Long/Short Equity Strategy Works
The mechanics of the Long/Short Equity Strategy are straightforward. On the 'long' side, you purchase stocks expecting their prices to rise over time, resulting in a profit when sold. This process is similar to traditional investing.
The 'short' side is where it gets a bit more complex. Short selling involves borrowing shares from a broker and selling them immediately at the current price.
If your prediction is correct and the price drops, you can buy back the shares at the lower price, return them to the broker, and pocket the difference. This allows the strategy to profit from increasing and decreasing market prices.
Signal Types for Long/Short Equity
How do we decide which stocks to go long or short on? Enter 'signal types'. These signals come in various forms, but the most common ones are fundamental analysis, technical analysis, and quantitative analysis.
Fundamental analysis involves studying the financials and operations of a company to determine its intrinsic value. If the intrinsic value exceeds the market price, the stock might be a good candidate for a long position.
Conversely, if the market price is inflated compared to the intrinsic value, it might be a candidate for a short position.
Technical analysis, on the other hand, involves studying price movements and patterns in the market. Traders use charts and various technical indicators to predict future price movements. Lastly, the quantitative analysis uses mathematical and statistical models to identify trading opportunities.
Performance in Different Markets
The versatility of the Long/Short Equity Strategy allows it to perform in different market conditions. In a bull market, where most prices rise, the long positions are likely to profit. But what about the short positions? Well, even in a bull market, not all stocks rise equally. Some may underperform, allowing the short positions to profit.
Short positions can boost the returns in a bear market where prices are falling. You can still realize profits even when the market declines by betting on declining prices. This versatility is one of the primary reasons the Long/Short Equity Strategy is popular among hedge funds.
Examples of Long/Short Equity Trades
Let's break down a simple example to illustrate how the long/short equity strategy works.
Let's say an investment manager has identified two companies in the same sector: Company A, which they believe is undervalued, and Company B, which they believe is overvalued.
- Long Position on Company A: They decide to take a long position on Company A, believing its stock price will rise. They buy 100 shares at a price of $10 per share, investing a total of $1,000.
- Short Position on Company B: At the same time, they decide to take a short position on Company B, believing its stock price will fall. They borrow 50 shares of Company B (from a broker), selling them at the current price of $40 per share, and thus receive $2,000.
Case Study 1: Successful Long/Short Equity Trade
The manager's predictions were correct, and the prices changed over the next few months.
- Company A's stock price rises to $15. The long position is now worth $1,500 (100 shares x $15), realizing a profit of $500.
- Company B's stock price falls to $30. The manager buys back the 50 borrowed shares at this lower price ($1,500 in total) to return to the broker. They make a profit of $500 on the short position ($2,000 received initially - $1,500 to buy back the shares).
The total profit here is $1,000 ($500 from the long position and $500 from the short position), and the strategy worked well in this case.
Case Study 2: Unsuccessful Long/Short Equity Trade
Now, let's assume the manager's predictions were incorrect.
- Company A's stock price falls to $5. The long position is now worth $500 (100 shares x $5), realizing a loss of $500.
- Company B's stock price rises to $50. The manager must buy back the 50 borrowed shares at this higher price ($2,500) to return to the broker. They lose $500 on the short position ($2,000 received initially - $2,500 to buy back the shares).
The total loss is $1,000 ($500 loss from the long position and $500 loss from the short position).
Jazz Pharmaceuticals Stock Pitch Example
This example delves into the long equity strategy, spotlighting the stock pitch for Jazz Pharmaceuticals [JAZZ]. Analysts recommend buying JAZZ at roughly $130.
Fast forward eight months, and the share price oscillates between $160 and $170, reflecting an impressive 27% rise in under a year.
The rationale for advocating a long position was based on the following:
- The market's overreaction to a disappointing earnings report with a 25% dip in sales of the company's principal product (Xyrem) did not account for the fact that most patients were transitioning to a superior, newer medication.
- An underestimation by the market of the revenue potential from its substitute drug Xywav acquired Epidiolex, Zepzelca, and several Phase 2 and 3 trial drugs.
- Anticipated positive events within the coming 6-12 months, such as a potential lawsuit settlement favouring the company, additional approved uses for the new drugs, and possible progressions to Phase 3 trials (to be revealed in upcoming earnings reports).
- The company's valuation appeared significantly lower than peer companies, historical transactions, and the DCF. We believed that risk factors like competition, integration of the acquired company GW Pharma, and failed clinical trials were controllable.
A traditional long-only asset manager, such as one at a mutual fund, faced with the same company would have two choices: invest in JAZZ or stay put.
However, a long/short equity hedge fund could consider several other alternatives:
- Invest in JAZZ and short a biopharma index or ETF to hedge against industry risk.
- Purchase call options on JAZZ rather than owning the stock directly.
- Take a long position on JAZZ and acquire put options on the company if the stock price goes south.
- Go long on JAZZ and also a direct competitor if a pending lawsuit or drug approval could impact both companies differently.
Most hedge funds employing this strategy lean towards a long bias, allocating more capital to long positions than short ones.
For instance, a hedge fund managing $1 billion in assets might invest $700 million in long positions and $300 million in short ones. The gross exposure would be $1 billion, while the net exposure would be $400 million. If the fund utilizes leverage - borrows funds to increase its returns - it could have $1.4 billion in long positions and $600 million in short positions, leading to a gross exposure of $2 billion (200% of its AUM) and a net exposure of $800 million.
A handful of funds employ market-neutral strategies where long positions balance out short ones, resulting in a net exposure close to 0%.
Risk-Return Profile of Long/Short Equity
The risk-return profile of any investment strategy is a vital aspect to understand. In a long/short equity strategy, the profit potential exists whether the market is rising or falling, providing a balanced risk-return profile.
However, it's essential to remember that going short can expose you to significant risk. If a stock's price rises significantly, the cost to buy back the shares for returning to the broker can result in substantial losses.
On the other hand, going long limits the loss to the amount invested, as a stock price cannot fall below zero. The blend of these two approaches—long and short—can help hedge funds manage risk while seeking returns.
Who are the top Long/Short Equity Hedge Funds
Almost all multi-manager hedge funds employ long/short equity strategies. The compilation of "leading funds" can vary depending on whether you include diversified platform funds such as Bridgewater Associates and Millennium Global Management or focus on smaller funds specializing in L/S equity.
Additionally, the rankings can differ based on whether the funds are sorted by AUM or performance and the considered timeframe.
Certain hedge funds are renowned for their long/short equity strategies despite these complexities. These include Point72, Viking Global Investors, Select Equity, Maverick Capital, Lone Pine Capital, and Davidson Kempner.
In the UK, the list extends with names like Marshall Wace, Man Group, Lansdowne, and Egerton Capital.
Moreover, if you consider long-only hedge funds, funds like Baupost Group also contribute significantly to the industry.
Additional Points
Beyond the core components of the long/short equity strategy, it's worth considering how this strategy fits into a broader portfolio context.
For instance, incorporating long/short equity into your portfolio can aid in diversification, helping you spread risk across various types of investments. It's also interesting to compare long/short equity to other hedge fund strategies, such as event-driven or global macro strategies, each with its unique risk/return profile.
Consider how market regulations can impact the long/short equity strategy. Certain regulations limit the ability to short-sell or require specific disclosures that can influence the strategy's execution.
Conclusion
While complex, the long/short equity strategy offers a unique approach to generating returns in various market conditions. By understanding how it works, including its signal types, performance, risk-return profile, and the effect of market regulations, you can make informed decisions about whether it suits your investment goals.