What is Long-Short Equity?

Key Takeaways

• With this method, a trader assumes long positions in equities that are expected to appreciate, while simultaneously taking short positions in stocks expected to decline.

• Long-short equity can help individual investors craft a portfolio that is less correlated with public market volatility.

• Over the long term, the long-short equity strategy can be profitable if the undervalued stocks go up and the overvalued equities decrease.

One strategy used primarily by mutual fund managers and hedge funds to minimize investment risk, even in a down market, is called long-short equity. The approach involves having both long and short positions and can help individual investors craft a portfolio that is less correlated with public market volatility.

But just what is long-short equity? Here is that and more.

What is a Long-Short Equity Strategy?

To infuse resiliency into portfolios, reduce market risk, and maximize portfolio returns, traders sometimes employ what is known as a long-short equity strategy. As the name implies, the approach involves investing in long as well as short assets.

With this method, a trader assumes long positions in equities expected to appreciate, while simultaneously taking short positions in stocks expected to decline. Over the long haul, the strategy can be profitable if the undervalued stocks go up and the overvalued equities decrease.

Hedge funds that use the strategy frequently take a market-neutral approach, in which the same dollar amount is invested in both long and short positions. This approach is discussed further below.

How Does a Long-Short Equity Strategy Work?

The method, also called hedging, involves taking advantage of profit opportunities in prospective upside as well as downside anticipated price movement. The trader first identifies then takes long positions in equities that are comparatively underpriced, while at the same time selling short stocks that are considered overpriced.

In other words, when aiming to go long, investors hunt for opportunities that can produce either income, growth, or some combination. When taking short positions, though, investors believe that a stock’s price will drop. So, they seek out undervalued stocks.

What are the Different Types of Long-Short Equity Strategies?

There are various strategies that fall under the long-short equity strategy approach. One strategy that is often employed by hedge funds is called “130-30,” which is more favorable to long positions. It basically calls for investing 130% of its capital in long positions, with the 30% coming from shorting. Shorting is when an investor tries to profit when a stock’s value drops.

Another strategy that falls under the overarching classification of long-short equity strategy is called “market neutral,” also known as a zero-net or low-net approach. It tends to have relatively low market risk and volatility and aims to produce returns through stock selection.

To lower risk and protect capital, there are some actions managers of market-neutral strategies can take, including:

• Lessening overall portfolio gross exposure by simultaneously selling longs and covering shorts
• Reducing position sizes
• Adding futures, index hedges, or margins for more portfolio protection

There is also a strategy called “sector specific,” which homes in on a specific industry or sector, such as technology, banking, or pharmaceuticals.

Another strategy, “geographic,” involves investing in specific markets or global regions, such as Europe, the United States, or new and emerging markets.

What is an Example of Long Short Equity?

Say the long-short equity fund finds that, at $85, the pharmaceutical company Merck is underpriced, and that at $75, Thor is overvalued. The fund can go long on Merck with $70,000 and short $30,000 in Thor stock. In other words, the fund purchases 823 shares of Merck and shorts 400 Thor shares.

If, as expected, Merck increases to $95 per share and Thor drops to $65 for each share, the fund’s profit would be $8,185 from Merck and $4,000 from the Thor short position. Therefore, the funds profits both from the Merck increase and Thor decline.

What are the Benefits of Long-Short Equity Strategies?

There are benefits to long-short equity strategies, primarily involving potentially mitigating risk. Further, such a strategy usually permits the flexibility to modify one’s risk profile whenever market conditions change. What is more, there is no requirement to maintain static exposures, and such strategies are not tied to a benchmark.

Other key benefits include:

• Potential for returns. Because there is less reliance on upward markets in long-short strategies, there could be returns from rising as well as dropping prices.
• Portfolio diversification. With long-short investment strategies, managers buy equities that are expected to outperform the market, while taking short positions in assets they believe will underperform. The net effect is a broadening of the potential for profits due to a more diversified portfolio that is less correlated to public market movements.

What are the Risks of Long Short Equity?

There is no guarantee that past performance equates to future results. With that in mind, note that long-short equity investors will face these risks:

• Leverage. There is a risk of loss due to unanticipated interaction between long and short assets, or to improperly hedged holdings.
• Market. There is always the risk of loss due to the effect of market movements in general.
• Short-sale. There is an inherent risk that, because of stock market appreciation, an investment that is sold short will produce substantial losses.
• Idiosyncratic. There is also a risk of loss due to factors that are company specific and are usually uncorrelated to wider market movement.

Also note that it is recommended that individual investors who are mulling long-term equity funds should factor in fees, which are usually more than the average mutual fund partly due to higher shorting and leveraging costs, and more frequent fund training. Higher fees can eat into profits.

Also, because such funds generally utilize more complex investment strategies, they tend to carry more risk than traditional mutual funds.

Adding long-short funds to one’s portfolio could indeed be beneficial. However, the following factors should first be considered:

• Investment goals. Investors would do well to discuss their investment objectives with their financial advisor and determine whether adding a long-short fund is aligned with their return expectations and overarching investment approach.
• Risk tolerance. There is the potential for major losses because funds can include short positions. Thus, it is likely a good idea for each investor to set their own risk tolerance, then invest in line with that.
• Mixed fund performances. It is the portfolio managers who establish long-short fund strategies. Thus, individual fund performances can vary. It is widely recommended that investors research their fund options and, before choosing one, fully understand the strategy.

What are Other Portfolio Management Strategies?

In addition to long-short equity, there are other types of portfolio management strategies, including one that’s income-oriented. Often employed by older investors such as retirees, the approach seeks to generate income that the investor can live off of.

Another strategy focuses on tax efficiency. Some investors, mostly high earners, wish to chiefly minimize taxes, even at the sacrifice of potentially better returns.

While no strategy is without risk, an increasingly popular – and necessary — approach is diversification of investment holdings. A more modern portfolio with a mix of stocks, bonds, and alternatives can mitigate overall portfolio risk and volatility. In fact, most financial planners agree that diversification is one of the essential elements of a sound investment strategy.

Alternative Investments and Portfolio Diversification

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments. This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.

To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

To maximize portfolio returns and lessen market risk, some institutional investors turn to long-short equity investing. They can potentially use leverage as well as derivatives to produce greater returns and manage risk.

But due to its nature and relative complexity, the strategy may generally be less appropriate for regular investors. However, balancing long and short approaches can potentially help such investors establish a portfolio that is not as subject to market swings. This will give individual investors opportunities for gains that outperform the wider market.

A growing strategy for retail investors is portfolio diversification – adding alternatives to conventional holdings — which can also reduce risk and volatility while generating regular returns.