What is a Long-Short Equity Strategy? Everything You Need to Know
What is a Long-Short Equity Strategy?
A long-short equity strategy is an investment approach that aims to achieve positive returns by taking both long and short positions on specific companies. An investor who takes a long position on a company believes that the company’s share price will go up and deliver positive returns. Conversely, shorting a stock is a sophisticated technique applied when the investor thinks that the company’s share price will go down. Long-only funds seek opportunities that can deliver either growth, income or a combination of the two. Long-only funds typically invest in companies they believe to be undervalued. Long-short investment strategies realize returns by betting against overpriced stocks rather than avoiding them. Long-short funds resemble hedge funds but typically offer better liquidity, lower barriers to entry (hedge funds may require an initial investment in excess of $100,000), and lower management fees. Typically, this strategy might be suitable to investors with lower return expectations since the market does not drive returns. Derivatives or leverage are sometimes used to enhance returns or mitigate risk in long-short investment strategies. Diversification is another benefit that comes with this type of investing.
Key Learning Points
- A long-short equity investment strategy is often categorized as an alternative investment approach, which takes both long and short positions on the market
- Most long-short funds are defined as market-neutral or absolute-return, which means that they aim to deliver positive absolute return regardless of the prevailing market conditions
- Long-short investment strategies often make use of derivative instruments and leverage
How Does a Long-Short Equity Strategy Work?
Often referred to as 130/30 equity strategies, a long-short fund invests 130% of its capital in long positions by taking short positions using 30% of the original capital. For example, if a fund manager uses the traditional stock-picking approach of fundamentally researching and selecting stocks, that process would naturally filter the universe for stocks with good outperformance potential from those with a rather negative outlook. By combining them in a portfolio, the manager would invest 100% in the strongest ideas and take short positions of up to 30% of the portfolio the bottom-ranking ideas. If the short trades turn profitable, the proceeds would be re-invested in the long positions.
Implications for Retail Investors
Due to their nature and relatively complex structure, retail investors should consider several things before engaging in long-short equity investment strategies. Implementing a long-short fund into a broader portfolio could bring diversification benefits as these strategies tend to show a low correlation to the returns of the broader market. In addition, they might help mitigate some of the risks, especially during more turbulent market environments.
Despite having a lower fee structure than hedge funds, long-short equity funds still tend to have a higher expense ratio than most traditional long-only funds. The higher charges are to be expected as the short-selling element increases their transaction costs. However, these strategies are more accessible when compared to hedge funds, which generally require large initial investments and are only marketed to qualified investors such as high-net-worth individuals, sovereign wealth funds, or pension funds.
Below is a multiple-choice question to test your knowledge. Download the accompanying excel exercise sheet for a full explanation of the correct answer.