What is Long/Short Equity ?

Hedge funds apply a vast array of investment strategies which can be more or less complex. In this article, we shall focus on the Long / Short strategy…

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Hedge funds use a wide range of more or less complex investment strategies. This diverse set of strategies has lead hedge funds to classify them in certain categories. Several global categories of strategies can therefore be considered: Long / Short Equity, Merger Arbitrage, Convertible Arbitrage, Global Macro, Managed Futures. These are the global categories even though data suggests that other types of strategies are used and weigh heavily in portfolios. It must be immediately noted that performances and risks can differ widely according to the type of strategy applied. This brings us to ask whether it makes sense to talk about hedge fund risk without taking into account strategy diversity. It is therefore very important to develop a good comprehension of the various strategies applied. As specified by the title of this article, we shall focus on the strategy called Long / Short.

First of all, Long / Short Equity is a quite common strategy and it can be argued that it is in line with the hedge concept which focuses on risk neutralization instead of speculation. The main frame surrounding the Long / Short Equity is based on assessing value contradictions observed on the markets. This consists in taking a “short” position on the asset which is considered as overvalued and a “long” position on the undervalued one. The transaction is financed by short selling since the sums cashed in can be used to buy the undervalued asset. This is a typical example of what economists call a “self financed portfolio” in the sense that the portfolio finances itself. What is the impact of asset value variation? Regarding the long position, the return is positive when the value of the asset increases. The short position works inversely. Its return is positive when the asset loses value.

How does short selling work? First, the hedge fund manager looks for an asset which it considers as overvalued. Generally, the manager compares the assets belonging to the same sector in order to short the overvalued one and long the undervalued underlying. In order to limit the risks, the fund will diversify among different sectors. In order to shot sell, which equates to selling assets he does not own, the manager must borrow the assets from a third party. Usually, this is carried out by a “prime broker” who organizes the loan by an institutional investor. For risk management purposes, the “prime broker” will require a certain amount of collateral in order to guarantee the transaction. Besides, the manager must pay interest over the period during which the short selling position is maintained.

The advantage of Long / Short strategies is that they can lead to various sources of profit. Let us remind that investors are looking for assets which are not correctly evaluated and that according to financial theory, they will generate an abnormal performance measured by “alpha”. If the fund chooses two assets within the same sector then the “betas”, which measure the general correlation between the market and the economy, will likely be the same for the assets. On of the assets is expected to have a positive alpha while the other is supposed to have a negative alpha. With a long position, it would be only possible to gain from the positive alpha. Yet, the possibility of short selling, which equates to the loss of value of the asset leading to a gain, allows positive alpha to be generated from the asset considered. Double strategy alpha is often highlighted.

There are however other sources of revenue that can be significant. Short selling generates cash and the broker then applies a discount on the interest that the manager is supposed to pay. Besides, the collateral deposited in a broker’s account is also a source of interest. Finally, during the period considered, dividends may have to be paid. Of course, the hedge fund manager receives dividends on his long positions. That said, he has to reimburse dividends received on the borrowed asset. In fine, he shall receive the dividend differential between the two assets considered.

From a portfolio theory point of view, the strategy considered brings new cards to the table. Indeed, portfolio theory dealing with long positions shows that the manager will ideally invest in inversely correlated assets for risk diversification purposes. This is no longer the case with short selling since positively correlated assets can be used to set up negatively correlated positions. In fact, it can be shown that short selling possibilities broaden the efficiency frontier. This translates into investment opportunities.

Long / Short strategies can however be more or less be biased depending on whether the “short” positions are greater than the “long” ones. We can therefore make the distinction among three subcategories: Equity Market Neutral which aims at achieving a neutral position, Dedicate Short which only takes short positions and finally Long Biased whose long positions exceed the short ones. In this respect, we must note the difficult faced by funds aiming for neutral positions. Considering the fact that the value of long positions tends to increase when that of short positions falls, neutral positions are hard to maintain. This implies frequent portfolio rebalancing and that most of these funds have a “long” bias.

The reader can ask himself why these funds are supposedly so risky. This can be explained by the fact that if the assets move in opposite directions (long assets losing value and short assets gaining), the double alpha works in the opposite direction and the losses are therefore greater. Another source of risk is the strong leverage that can result fro short selling since most of these funds have positions which are several times the level of their capital. Finally, collateral can lose value. This has unfortunately been observed during the previous year.

Michel Verlaine April 2008

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