Long/Short Hedge Fund Strategies
The Long/Short Equity is an investment strategy that involves taking both long and short positions simultaneously. The strategy is mostly used by hedge funds to reduce the portfolio sensitivity to the broader equity market movements as volatility and beta are presumed to decline with this strategy compared to its long-only counterpart.
The use of a Long/Short Equity strategy in a broadly diversified portfolio can help in generating profits from both long and short positions along with offering a hedge against market uncertainties. The strategy works as a hedge against market volatility because gains from short positions will offset losses from long positions.
What is a Long/Short Strategy
Long and short are two different trading strategies. Investors go long on stocks that they believe will appreciate in value both in the short and long run. Going long would mean that the investor is bullish on the future fundamentals of the company. On the flip side, when investors seek to profit from the downside movement, they short the stock.
When both strategies are used simultaneously, it is called a long/short strategy. Long-Short equity strategies aim to minimize risk while profiting from stock price declines in the short positions and price gains in the long positions.
Benefits of Long/Short Equity Strategies
Below are a few potential benefit of Long/Short strategies:
Portfolio diversification: In a Long/Short investment strategy managers take advantage of both upside and downside movement of stock prices, this strategy helps in adding more stocks to a portfolio.
Higher returns: Since Long/Short strategies are less dependent on rising markets, there is the potential for positive returns from both rising and falling markets.
Lower volatility: Long/Short Equity strategy helps in reducing portfolio volatility as hedge fund managers generally hold both bullish and bearish positions.
Categories Under the Long/Short Equity Strategies
Long-short equity encompasses a range of strategies. The strategies are not designed for rocket-soaring gains, but they may produce steady returns over the long term with less risk. Long-short equity hedge funds strategies fall under three main categories:
Sector-specific: Long/Short hedge funds target a particular sector or industry to maximize returns and minimize volatility like technology, banking, or pharmaceuticals. They can, for example, place a long bet on a stock in the technology sector and a short bet on a company within the same industry that is having difficulty meeting average industry growth rates.
Geographic: Hedge funds with global market exposure target stocks from specific regions of the world. Hedge funds seek to target specific markets like Europe or the US when using a long-short strategy. For example, the BlackRock Global Long/Short Equity Fund chooses global stocks using a fundamental approach. It seeks to reduce volatility by diversifying portfolio holdings. It also uses a variety of hedging strategies that focus on geographies, sectors, and market neutrality to minimize net exposure to the market.
Market neutral: Generally, hedge funds use market-neutral strategies to outperform market returns regardless of the broader market conditions. In the case of a market-neutral strategy, the portfolio manager makes both short and long investments to capture the spread. A significant dispersion between the top and worst-performing stocks makes this method most effective. For Instance, Vanguard Market Neutral Investor Shares Fund (VMNFX) determines which companies to short by evaluating five factors: quality, growth, management decisions, valuation, and sentiment.
The Risk with Long/Short Equity Strategies
Performances in the past do not guarantee better results in the future. Long-Short equity investors should consider three main risks:
Company-specific risk: Sometimes unforeseen events could strongly impact the company’s financial performance and future fundamentals. Therefore, its stock price could move in a different direction.
Short position risk: Short positions are extremely risky. A stock can fall to a zero level, but theoretically, there is no upside limit. This means a short position could expose investors to unlimited losses compared to a long position.
Higher Fee: Commonly, long/short hedge funds have higher fees relative to traditional funds. This is the reason their average expense ratio stood around 1.9% in 2016 compared to the traditional hedge funds average of 0.57% according to Morningstar.
The equity markets are experiencing unprecedented times over the past two years, and investors should look for strategies to enhance the resiliency of their portfolios. Hedge funds are increasingly using Long/Short strategies to strike a balance between profit-seeking and risk mitigation. However, before choosing any hedge fund with a Long/Short strategy, it is key to gauge whether the fund manager’s investment philosophy and track record match your investment objective and risk tolerance.
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