Understanding Long/Short Equity Investing Strategies
- What does “shorting” and “being long” mean? Defining gross and net exposure.
- A short thesis may take a long time to generate profits. For example, Wirecard.
- Meaning of equity market neutral portfolio.
- Asset Manager Hamilton Lane stated, “Long/short equity strategies have come close to matching the performance of equities with a lower level of volatility than the 60/40 stock/bond portfolio, and with smaller drawdowns.”
Long/Short equity investing is a widely employed strategy in the hedge fund industry.
There are numerous advantages to this strategy, which contributes to its popularity among investment professionals seeking to run their own funds.
Yet there are some disadvantages, and the strategy has had its fair share of performance issues over the last cycle possibly due to the consistent upward drift in equity markets leading to diminishing performance on the short side of the investment book.
Institutional Investor wrote that in the past 5 years, “the average equity long-short hedge fund saw gains that represented about one-quarter of the upside in stock markets and 100 percent of the downside of equities”
Another potential theory for the recent lagging performance of this strategy can be attributed to its popularity. Markets are ruthlessly efficient, and the past success of this strategy attracted a lot of interest to the space which ultimately competed away returns.
Despite at least half a decade of underperformance, prospects may be bright for this strategy, with some investment managers proclaiming that Long/Short may just be the new 60/40!
What is Long/Short Investing?
Before defining the overall strategy, it is important to cover what short selling or “shorting” is. According to Investopedia, “Short selling is an investment or trading strategy that speculates on the decline in a stock or other security's price.”
Investopedia further states that “In short selling, a position is opened by borrowing shares of a stock or other asset that the investor believes will decrease in value. The investor then sells these borrowed shares to buyers willing to pay the market price. Before the borrowed shares must be returned, the trader is betting that the price will continue to decline, and they can purchase them at a lower cost.”
To summarize, “shorting” means to borrow shares with the hope that the price declines. Often, we view a short as a bet that the company’s share price will fall.
Conversely, to be “long” means to purchase a company’s shares to hold for a duration of time. As with most asset purchases, we buy something thinking that the value will be greater in the future.
Building off that definition, Long/Short investing combines both long and short trades. Under this trading strategy, investors seek to generate returns through both upward movements in their long book and downward price movements in their short book.
With long/short investing, investors have both gross and net exposures to the market.
Gross exposure adds the amount of assets an investor is long with the amount of assets that the investor is short.
Gross = Long + Short
Net exposure subtracts the amount of assets an investor is short from the amount of assets that is long.
Net = Long - Short
We will speak more to this later.
Long/Short Equity Investing Struggles
In July 2020, the Financial Times reported on a well-respected firm from the UK shutting down its short strategy, stating, “Lansdowne’s problems reflect the wider challenges facing the $830bn-in-assets equity long/short hedge fund sector.”
The report indicates that, as of last summer, managers have employed this strategy for nearly $850 billion in assets. Yet despite the popularity of this strategy, markets have drifted upwards since the end of the Great Recession and short investors have struggled.
Adding insult to injury, a perfectly good thesis can go unrewarded for quite a long time. Take the example of Wirecard.
The Wall Street Journal reported that German regulators received reports concerning the company as early as 2008! If you had the audacity to short a company that currently trades at $0.16 as early as 2017, you could have been nursing serious losses in your short book as the company went from $20 to $120!
Financial Times, July 2020. “Crunch time for long/short funds after Lansdowne calls it quits.”;
The Wall Street Journal, July 2020. “How Germany’s SEC Dismissed a Decade of Warnings About Wirecard.”
Different Net and Gross Exposures
As we stated earlier, gross exposure is measured by adding the amount of assets an investor is long with the amount of assets they are short. Net exposure subtracts the amount of assets an investor is short from the amount of assets they are long.
So, investors can play with the weights to get to different exposures to the market.
For example, an investor can be 150% long and 50% short. This would make the gross exposure of the investor 200%, while only having 100% net exposure. When an investor borrows stock and sells it, in the process of going short, borrowing the stock is similar to borrowing cash! So, the investor is levering up their portfolio, using the new cash to buy more stocks, while still having the same broad amount of exposure to markets as a simple long investor because they are 100% net long.
Another example is an investor who is 50% long and 50% short. This is more conservative for multiple reasons. The investor in this case is borrowing shares but has cash on hand to net out his borrowing. The portfolio has 100% gross exposure, or half as much as our previous example. However, the net exposure of the portfolio is 0% because the long and short portions of the portfolios cancel each other out.
This type of portfolio is called market neutral. Investors who do this are explicitly saying that they do not want to bet on the direction of the market. The portfolio manager in our prior example would likely have taken the view that the market was likely to move higher since the portfolio is taking market exposure (100% vs 0%).
One can go market neutral, 0% net exposure, by having a higher gross exposure. For example, an investor could be 100% long and 100% short.
Looking for Alpha in Long/Short Equity Investing
Asset Manager Hamilton Lane stated, “Long/short equity strategies have come close to matching the performance of equities with a lower level of volatility than the 60/40 stock/bond portfolio, and with smaller drawdowns.”
Enhanced Risk/Return Profile
Historical returns of long/short equity strategies have been comparable to those of long-only strategies, with half of the risk.
Source: 361 Capital
This is particularly important in a world with low rates, a topic we have touched on numerous times before. With interest rates extremely close to the zero lower bound, the approximately 40% of retirement portfolios that have traditionally performed well when equities sell-off may no longer have the ability to generate meaningful returns in a market downturn.
Long/Short can be a useful tool for building robust portfolios. Within the Long/Short Equity Investing categories, there are different styles, sectors, and exposures for investors to choose from. Some managers will be industry specialists and others will be generalists who will trade any industry.
Long/Short investing offers plenty of options within its ranks.
Despite these benefits, Long/Short equity investing has lagged the broader market. Shorting, in particular, comes with added risks due to the cost of borrowing shares, and the new craze where retail investors seem to target stocks with high short interest.
Long/Short Equity Investing is a popular investment strategy. The defining feature of the strategy is the fact that it combines the tactic known as shorting a stock, a bet on it going down in price, with the more well-known method of buying stocks in anticipation of the stock appreciating or paying dividends. Long/Short Equity Investing is a broad strategy that allows for different gross and net exposures to the market overall. Being short has detracted from the strategy’s overall performance since the Great Recession due to persistent moves higher in the US stock market.