Hedge Fund Strategy - Equity/Long Short
Today, we are going to look at one of the oldest hedge fund strategies – Equity/Long Short. Some of you may know it by its other name - Equity Hedge. It is also the largest strategy slice in the hedge fund space in terms of Assets Under Management (AUM). Without breaking down into its sub-strategies, it accounts for 25% of hedge fund’s USD 3.8 trillion AUM as of 2020.
So, what exactly is equity long/short? Is the fund on the long side or the short side? How did it all start? What is it trying to achieve?
Equity Long Short - How & Why It Started
A fund that runs an equity long/short strategy is usually on both the long and short side of the stock market at the same time. That is what gives it its name. And to know how it started, we have to trace it all the way back to when the very first hedge fund began!
The very first hedge fund is an equity long/short fund started by Alfred Winslow in 1949. While some of you might contest this, he was credited in much literature as the founding father of hedge funds.
But in any case, this is not the main focus here. What is of interest is what exactly he intends to achieve through a long/short strategy. And he outlines his thoughts and principles behind it:
He believes he has superior stock-picking skills.
He knows he is unable to predict where the broader stock market moves.
So, he bought stocks he thought were good and shorted those he thought are bad. The net result is a portfolio that was less sensitive to broad stock market movements because the market exposure of the stocks he long and those he shorted offset each other to various degrees. In more technical terms, the Beta of the long and short positions cancel each other out somewhat.
But that also means his profits will now become highly dependent on his ability to pick the right stocks. Again, in technical terms, profits or returns driven by one's skills are called Alpha. Theoretically, as long as the stocks he bought outperform those he shorted, he would be able to make money regardless of how the stock market moves. The most perfect scenario of course would be the case where the stocks he bought rise while those he shorted tank. In this scenario, he will make money on both sides. In addition, he also took on leverage to amplify the return of his portfolio. That means he borrowed money to increase the size of his positions.
Now, if we fast forward everything till today, this still pretty much describes what many equity long/short funds do.
Common Terminology on Equity Long/Short Funds
When we deal with long/short funds, you will almost always come across these commonly used terms:
Long and short book. To track performances, portfolio managers often segregate their long and short positions through internal accounting into a long book and a short book. As you can probably tell, the long positions sit in the long book, and the short positions in the short book.
Long exposure. Unless explicitly stated, the term exposure here refers to the percentage of dollar capital invested in the stock market. And in this case, the long exposure is simply the percentage of capital invested into the long book. If I run a $100 million dollar fund and my long exposure is 100%, that means I invested $100 million dollars into my long positions. This is just an example. In practice, a fund can run a higher or lower exposure than that at any point in time.
Short exposure. The short exposure is the percentage of capital used for the short book. Riding on the example for the long exposure, if I also short $100 million worth of stocks in my short book, that means my short exposure is also 100%.
Gross exposure. This is the total absolute exposure taken by the long/short fund. So if my fund runs 100 100% long and 100% short exposures at the same time, it has a gross exposure of 200%.
Net exposure. This exposure takes into account the directional nature of the longs and shorts. So if I have both 100% long and 100% short exposures, my net exposure is 0%. Such a portfolio is also known as a dollar-neutral portfolio. However, do note that this is not the same as a market-neutral portfolio. The two are often mistaken to be the same. A market-neutral or beta-neutral portfolio is constructed such that the betas of both the longs and shorts offset each other. Or at least, that is their target. A dollar-neutral portfolio, on the other hand, does not take beta into account and is often not beta-neutral.
A Simple Long/Short Portfolio
Let's go through a simple example using US stocks assuming the following setup.
Long Book: American Express, Microsoft, Goldman Sachs
Short Book: Disney, Intel, Verizon
Target Long Exposure: +100%
Target Short Exposure: -100%
Target Gross Exposure: 200%
Target Net Exposure : 0%
Stock Weights: Equal Weighted
Rebalancing Frequency: Daily
Trading Costs: Assume no costs
For simplicity, let's assume there are no costs and we are able to rebalance the portfolio at the end of every trading day so that all stock holdings are equally weighted. So how would such a long-short portfolio fare during 2021 and 2022? The 6 chosen stocks in this portfolio came from the Dow Jones Industrial Average Index so let's compare it against the Dow Jones Industrial Index ETF (Ticker: DIA) as well as an equally weighted long-only portfolio comprising these 6 stocks.
The example long/short portfolio fared better than both the DIA and the long-only portfolio. It delivered a positive return even in 2022 despite a US stock market downturn brought about by sky-high inflation and aggressive US Federal Reserve hiking rates rapidly. With the right picks on both the long and short sides, the portfolio is able to make money regardless of where the market moves. While this portfolio is not market neutral, its average Beta (vs DIA ETF) calculated using monthly returns over the 2-year period is just 0.18 which is on the low side. And average monthly Alpha is 2.3% which is very high.
But this fantastic performance is primarily due to hindsight. I deliberately picked stocks that would yield favorable performance over these 2 periods to highlight what a long/short strategy ideally wants to achieve. Another factor is concentration because I only have 3 securities on each side of the trade to keep this example simple. Most long/short funds will be far more diversified than that. Finally, there is leverage because I am running at a gross exposure of 200%. And in this case, since I am right on my bets, it pays off. But if I am dead wrong, and both my longs and shorts lose money which can happen, then I will pay a heavy price.
More About Equity Long/Short
Most equity long/short funds are long-bias funds. This means the funds run a net-long exposure most of the time. But they can be net-short at times. This gels with the fact that most equity long/short managers came from a long-only background and given also that the stock market tends to rise over the long term.
There are dedicated short-bias funds but very few. There are some funds that run a dedicated net short bias. But these are few and far between and usually, they are classified as a separate strategy from equity long/short. Why are such funds so rare? Because it takes more specialized skills and it is very hard to make money on the short side consistently over time. These funds tend to lose money until a market downturn hits that is if they are still in business then. They are usually positioned as a hedge and those who are interested in such strategies are typically institutional investors.
Market-neutral equity long/short is just another type of equity long/short. Even though these funds are often carved out as a separate strategy, I consider them as a form of equity long/short. What sets them apart is that they try to maintain their portfolio's beta close to zero. The objective is to have a portfolio whose returns are driven largely by alpha and independent of the market.
There are different ways to construct a long/short portfolio. The simplest and most direct way is to rank the stocks in your universe according to a set of criteria or scoring methodologies. This will differ from one fund to another. Then select the top-performing stocks (e.g. the top decile) to buy and the worst-performing stocks to short (e.g. bottom decile). In this case, there is no other specific relationship between these 2 groups of stocks. Your consideration is solely based on the merits of each individual stock and its expected performance. But we can also construct a long/short portfolio by identifying pairs of stocks to go with one another. For example, you may select and size up pairs from a specific sector based on how far their relative valuations or some other statistical measures deviate from the historical or expected norm. The portfolio then comprises a range of calibrated pair trades. Such funds may be classified under relative value or arbitrage.
Many equity long/short funds use leverage to amplify their returns. The use of leverage is prevalent among equity long/short funds and other types of hedge funds. The idea of a long/short strategy where you can simultaneously make money both on the long and short side sounds nice. But in reality, it is far from easy. The usual case is this. If you make money on your longs, your shorts are likely bleeding and dragging your performance down, and vice versa. But as long as one side makes more money than what the other side loses, you make a profit. That is the gist of it. Diversified and well-run long/short portfolios tend to have lower risk than the market but there is one issue - returns also tend to be lower. So this is where leverage comes in to boost the results. But of course, leverage is a double-edged sword so it can swing things both ways.
How Did The Real Thing Perform?
Let's look at how equity long/short hedge funds performed against the global stock markets since 1998. The HFRX equity hedge index is used to represent the performance of equity long/short hedge funds net of all fees, while MSCI World is used to represent the performance of global stocks.
As you can see, prior to the Great Financial Crisis (GFC), equity long/short hedge funds as a group did very well relative to the global stock market. In fact, it did spectacularly during the Dot Com bust period, delivering positive returns while the stock market sank. However, things took a turn when GFC hits and thereafter. It seems that equity long/short funds have become more correlated with the market in terms of the direction it moves. But unlike the stock market which has recovered and moved up rapidly since the GFC, equity long/short funds have stayed relatively range bound. They lost the headstart they racked up against the stock market and only broke past the high it made prior to GFC not too long ago.
Aside from tougher competition as more and more funds chase after the same alpha, many also attribute these changes to the massive quantitative easing pursued by central banks after the GFC. The flood of money released chased up asset prices, depressed volatility, encouraged speculation, and erodes the alpha of hedge funds. Personally, I would not be surprised if some of these funds also start to take a larger net long exposure in order to stay afloat which will in part explain their increasing correlation with the stock market.
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