What is Long / Short Equity

Long / Short Equity is an investment strategy designed to reduce downside risk exposure and increase risk adjusted returns. In this snippet we explain how the Long / Short Equity strategy works and also compare the performance of Long / Short Equity funds to the traditional Equity funds over the past 5 years and also over the past 12 months.

In today’s volatile equity markets, it’s very important that investors manage their downside risk. Investors have various investment strategies available to them to protect against potential downside risk in equity markets, these include:

  • Equity Structured products;
  • Protected Equity funds;
  • Long / Short Equity funds;
  • Long / Short Equity Fund of Hedge funds;
  • Managed Volatility funds;
  • Hedging overlays.

In this article we focus on Long / Short Equity as an investment strategy. This strategy was pioneered in the hedge fund industry in the 1980’s and has since been adopted by various types of investment funds. The basic strategy for Long / Short Equity is to take a long position (buy) in stocks that are expected to increase in value and a short position (sell) in stocks that are expected to decrease in value.

To take a long position in a stock simply means to buy the stock with the hope that the price will appreciate. The appointed investment manager will go “long” if he expects the value of the stock to increase. To take a short position in a stock means to borrow a stock you don’t own (usually from the broker or a bank), then selling that borrowed stock hoping it declines in value so you can buy it back later at a cheaper price and then hand it back to the lender. Both long and short positions work on the principal of “buy low, sell high”. Taking a long position allows the investment manager to do so before the equity market rises and taking a short position allows the investment manager to sell high before the market falls and then to buy at a lower price again.

The investment manager can therefore effectively take advantage of both sides of the market i.e. make profits whether the markets rises or falls. Long / Short Equity strategies can therefore take advantage of falling markets whilst traditional Equity investment managers can only reduce their equity allocation for cash when they wish to reduce their exposure to falling markets. Most traditional Equity investment manager mandates however only allow them to allocate a maximum of 5% to cash so they actually don’t have much leeway to protect the portfolio if the market falls outside of positioning the portfolio in stocks that have limited downside.

Long / Short Equity strategies that hold equal Rand values of long and short positions are called Market Neutral strategies. Not all Long / Short Equity strategies are Market Neutral. Most Long / Short Equity strategies in fact maintain a long bias i.e. their general positioning still remains positive to benefit from a positive performing equity market.

Long / Short Equity strategies are not without risk. The strategy could lose money if the stocks move contrary to expectation, for example, if the stocks in which long positions are held decrease in value and if the stocks in which short positions are held increase in value. Investors should also understand other risks such as lower liquidity, high minimum investment amounts, lock-in periods, higher fees and
usually lower transparency.

GraySwan conducts detailed monthly peer group investment manager surveys on a range of more than thirty different investment strategies. The GraySwan Long Short Equity Hedge Fund ScoreCard compares the risk and return characteristics of the universe of South African Long / Short Equity Hedge Funds and Fund of Funds. Currently there are 29 funds which we monitor in this universe.

The following table compares the performance of the average Long / Short Equity fund with the performance of the average traditional Equity fund and the SWIX benchmark over a 5-year period ending January 2015. The aim of the analysis was firstly to judge how Long / Short Equity funds performed relative to traditional Equity funds and also how both these equity strategies performed relative to the market.

 Long / Short Equity AverageTraditional AverageSWIX
5 year "net" return11.06%12.41%14.44%
Standard Deviation6.35%13.87%14.62%
Efficiency Ratio1.740.890.98
2008 return0.41.%-18.01%-21.67%
Maximum Loss-5.84%-30.87%-36.54%
12 month Maximum Loss-3.33%-28.62%-34.51%

Over the past 5 years neither the average Long / Short Equity manager nor the average traditional Equity manager outperformed the equity market. It is however critical to note that the average Long / Short Equity hedge fund produced the highest effeciency ratio i.e. the best risk adjusted return.

The returns achieved during 2008 indicate just how efficient the Long / Short Equity strategy is in reducing downside risk. During the financial crisis in 2008, the Long / Short Equity Average achieved a return of 0.41% while the traditional Equity manager lost 18.01% and the SWIX lost 21.67%.

Furthermore, the Maximum Loss and the 12 month Maximum Loss results clearly show how Long / Short Equity funds protect investors from downside, albeit that they also lost capital. It is therefore critical to understand that whilst Long / Short Equity managers aim to protect capital there is no guarantee and short term losses can be expected.

During volatile short term periods, Long / Short Equity funds have produced superior results to that of traditional Equity funds and the market. For example, over the 12 month period ending January 2016 the average Long / Short Equity fund produced a return of 8.80% whereas the average traditional Equity fund produced -7.18% and the market yielded -2.66%.

Summary

Long / Short Equity strategies can enhance the risk adjusted nature of any equity investment portfolio. It is however important to conduct detailed investment as well as operational due diligence before selecting an investment manager after which daily performance and mandate compliance monitoring should be implemented.