- The equity long-short strategy is the most popular hedge fund strategy attracting the most capital among the hedge fund universe.
- A successful long-short strategy helps increase the efficiency of a traditional long-only investment strategy by taking advantage of profit opportunities from securities identified as both under- and over-valued.
- Conceptually, the strategy has the goal to invest at the same time in stocks on the long side (buying undervalued stocks) and on the short side (selling overvalued stocks). If a long-short strategy uses the exact same position size for longs and shorts, the investment strategy has no directional market exposure. Hence, the investment return is the pure result of stock selection (alpha).
- Equity long-short strategies are, on average, more liquid relative to most other hedge fund strategies.
The most popular hedge fund strategy
An equity long-short investor takes long positions in stocks that are expected to increase in value and short positions in stocks that are expected to decrease in value. Taking a “long position” in a stock simply means buying it: If the stock increases in value, you will make money. On the other hand, taking a short position in a stock means borrowing a stock you don’t own (usually from your broker), selling it, then if the stock declines in value, you make a gain as you can buy it back at a lower price than you paid for it and return the borrowed shares.
An equity long-short hedge fund strategy consists of buying an undervalued stock and shorting an overvalued stock at its most basic level. Ideally, the long position will increase in value and the short position will decline in value. If this happens and the positions are of equal size, the hedge fund will benefit. That said, the strategy will work even if the long position declines in value, provided that the long position outperforms the short position (means that the long position is down less). Thus, the goal of any equity long-short strategy is to reduce exposure to the market (typically described as “beta”) in general and profit from a change in the difference, or spread, between two stocks (typically described as “alpha”). On average, equity long-short strategies are more liquid relative to most other hedge fund strategies.
Sustainable value from stock selection
At Alpinum Investment Management, we focus on identifying equity-long short managers, who demonstrate their ability to sustainably generate value from stock selection both long and short. Ideally, the net market exposure (long minus short exposure) does not exceed a certain level (i.e. 30%) so that the market exposure (“beta”) is not the dominant return driver of the strategy. For example, if a manager is able to achieve a constant value creation from stock selection (typically described as “alpha”) of around 3% p.a. with a market exposure of on average 30%, the following results are achieved in a given 12 months-period: