The long and short of equity investment

“Equity Long/Short works especially well over the long term.”

In a challenging market environment, Equity Long/Short strategies–traditionally favored by sophisticated investors– have become increasingly popular. Daniel Insunza dissects this complex investment strategy, as a first step for investors to understand more about hedge funds.

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Daniel Insunza
Director, Investment Funds and Hedge Funds Singapore

When investing in equities, an investor could either invest in the ‘broad’ equity market (typically linked to a benchmark such as the S&P 500 or the MSCI World), or pick individual stocks with the potential to increase in value.

The outcome for the investor will be driven by two factors: the direction of the market, commonly called ‘beta’, as well as the timing of the investment decision and the individual stock picks, called ‘alpha’.

What is Equity Long/Short?

Although investors can invest in markets and pick stocks independently, there is a limit to how much they can adjust their market exposure. An Equity Long/Short manager, on the other hand, has the ability to borrow stocks, sell and buy them back later at a lower price, and benefit from any decrease in the stock price. This is known as going ‘short’. Managers will try to pick stocks that increase in value (long positions), and stocks whose values decline (short positions). This investment strategy is known as ‘Equity Long/Short’.

The chart below illustrates how Equity Long/Short managers make money. The blue bar represents the long position–‘blue’ is a winner and is expected to increase in value. Conversely, the light brown bar represents the short position– the loser that is expected to decrease in value. By taking a short position in a stock, managers can make a profit from a price drop by buying the stock back at a lower value. The manager’s ability to pick winners and losers correctly will determine the investment performance.

But that’s only the start: if we now subtract the short position from the long (80% minus 30% in our example), we achieve a net position. This net position broadly represents the exposure the manager takes to the equity market. Importantly, the manager has the ability to size his long and short positions such that he can influence the net exposure. Depending on which direction he sees the market moving, the manager may adjust his exposure to the market by increasing or decreasing its net exposure.

By adding the long and short positions, we get the gross exposure (80% + 30% = 110%). In our example, this means that for every $100 invested, $110 gets to work. Remember that shorting implies borrowing a stock; therefore the gross indicates the level of leverage.

To recap, an equity investor can either pick stocks (alpha) and time the decision, or buy into the market (beta). An Equity Long/Short manager has more ways to invest, such as picking stocks on the long and short sides, gradually increasing or decreasing market exposure, and applying leverage in varying degrees, either to increase exposure or to manage risk. The outcome for an Equity Long/Short manager is thus much more dependent on his decisions and skill rather than the direction of the market.

Does it work?

The evidence speaks for an allocation to Equity Long/Short. A quantitative analysis shows that an index of Equity Long/Short managers has achieved a higher return at a lower volatility, versus a passive investment in US Equity (S&P 500) or Global Equity (MSCI World). More importantly, the largest peak-to-trough losses have been substantially smaller for Equity Long/Short managers on average. When analyzed in more detail, it becomes apparent that Equity Long/Short managers achieved this outperformance mostly by avoiding the large losses that regularly occur in equity markets, while slightly underperforming markets in strong bull markets. Equity Long/Short strategies work particularly well in a market where stock picking is rewarded, i.e. when there are clear winners and losers.

Are there risks?

As with every investment, Equity Long/ Short strategies are not without risks. Portfolio managers have to correctly predict the performance of their stock picks, actively trade, and size the exposure to markets correctly. This is why the selection and monitoring of such investments are crucial.

How to use Equity Long/Short?

Given that Equity Long/Short works especially well over the longer term, it should really be a strategic allocation in a portfolio. As such, it can be viewed as part of the equity allocation. However, the active decisions in Equity Long/ Short, picking stocks, sizing exposure to the markets and applying different levels of leverage also qualify it as part of the hedge fund allocation in a portfolio.

We view the strategy positively in the current environment, due to two main factors: firstly, following a big run-up in equities, a more cautious approach to ‘pure beta’ equity investing seems sensible. Secondly, as we have observed more winners and losers appear over the last few quarters, picking stocks should therefore increasingly pay off. The sum of these factors–lower beta and the ability to pick stocks–makes for a compelling case in favor of Equity Long/Short.