Long-Short Equity

What Is Long-Short Equity?

Long-short equity is an investing strategy that takes long positions in stocks that are expected to rise in price and short positions in stocks that are expected to decline. A long-short equity strategy seeks to minimize overall market exposure, while profiting from both stock gains in the long positions, as well as the short positions. 

The long-short equity strategy is very popular with hedge funds, many of which employ a market-neutral strategy, in which dollar amounts of both long and short positions are roughly equal.

In fact, the long-short equity strategy is probably the oldest hedge fund strategy. It was established by the legendary Alfred Winslow Jones, who created the first widely recognized hedge fund in 1949. 

Compared to their long stocks only counterparts, long-short strategies are designed to have lower sensitivity to overall stock market movements, which translates to less volatility and smaller drawdowns. 

When included as part of a broadly diversified portfolio, this strategy has the potential to provide an element of risk mitigation, or hedge, when markets decline because the gains on short positions will somewhat offset losses on long positions.

Long-short complements traditional long-only investing, as it takes advantage of opportunities to profit from stocks identified as undervalued and overvalued.

Broadly speaking, there are two types of long short strategies. These include:

Market neutral which uses strategies aimed at minimizing sensitivity to outside market volatility. This strategy seeks to eliminate the impact of broad market movements by trading related stocks, such as two stocks from the same industry, on a long and short basis.

Extension strategies which utilize long and short investing, while aiming to provide 100% net exposure to the underlying market. The leverage for these types of strategies can vary, with the most common being 130/30 – that is 130% weighting in long positions and 30% weighting in short positions within the same portfolio. The extension strategies tend to provide greater diversification to the portfolio.

Why Invest Using a Long-Short Equity Strategy?

In theory, the “asymmetric return” profile makes a long-short fund one of the best ways to compound wealth for the long term. Basically, it lowers the risk of substantial losses and opens-up upside opportunities for equity-like returns.

For investors, there are several potential benefits of this strategy.

The first is portfolio diversification. This is because managers buy stocks they expect to outperform the market, while taking short positions in assets they expect to underperform. This expands the investment universe, offering the potential for a more diversified portfolio while still retaining a degree of correlation with equity markets.

Another benefit is the potential for excess returns. Long short strategies rely less on rising markets. However, because the funds include short positions, there’s also the potential for significant losses. 

History gives us evidence that this strategy usually works when the market is not doing so well.

During the bear markets of 2000-2002 and 2007-2008, the down markets of mid-2011 and late-2018, and the chaotic beginning of 2020 (as the COVID-19 pandemic unfolded), long-short equity strategies broadly, as measured by the HFRI Equity Hedge (Total) Index, and market-neutral strategies more specifically, as measured by the HFRI Equity Market Neutral Index, achieved their goal of mitigating downside risk relative to the broad market.

For example, in the 2000 to 2002 period, the HFRI Equity Hedge (Total) Index gained 23% and the HFRI Equity Market Neutral Index gained 4%. Meanwhile, the MSCI World Net index lost 42%.

History tells us that since 1997, there have been five years where the S&P 500 Index produced negative returns. During those same five years, a long/short equity strategy led to stronger returns by experiencing only 21.54% of the downside. In other words, investing in a long/short equity strategy provides the potential for a ‘smoother ride’ over time for your portfolio. 

However, the performance of long-short equity funds does depend on the acumen of the manager running the long-short equity fund.

Through mid-May 2022, Goldman Sachs estimated that long-short funds had lost 18.3% in 2022. The reason was that many funds’ longs were invested in the riskier corners of the stock market, including loss-making technology companies.

How to Invest Using a Long-Short Strategy

There are a number of funds and ETFs available to retail investors that offer access to this long-short equity strategy. For a look at these investment alternatives, check out www.magnifi.com and use their AI-assisted search function by typing in ‘long-short’.

Magnifi is changing the way we shop for investments, with the world’s first semantic search engine for finance that helps users discover, compare and buy investment products such as ETFs, mutual funds and stocks. Open a Magnifi investment account today.

The information and data are as June 9, 2022 (publish date) unless otherwise noted and subject to change. This blog is sponsored by Magnifi.