Long/Short Equity

Long–Short Equity

Long–short equity is an investment strategy that seeks profit from both rising and falling stock prices by holding long positions in stocks expected to appreciate and short positions in stocks expected to decline. It’s commonly used by hedge funds and other active managers to reduce market exposure, exploit relative mispricings, and aim for returns that are less correlated with broad equity markets.

How it works

• Long positions: buy stocks believed to be undervalued or positioned to outperform.
• Short positions: sell borrowed shares of stocks believed to be overvalued or likely to underperform.
• Net exposure: managers can target different net market exposures—from bullish long-biased portfolios to market-neutral allocations.
• Common variations:
• Long-biased strategies (e.g., 130/30): hold 130% long and 30% short (net 100% long) to increase exposure to long ideas while funding shorts.
• Market-neutral strategies: aim for roughly equal dollar amounts long and short to minimize market beta.
• Strategy scope: funds differ by geography (developed vs emerging markets), sector (technology, healthcare), or investment style (value vs growth).

Comparison with equity market neutral

• Long–short equity broadly includes any mix of longs and shorts; equity market neutral (EMN) specifically targets equal long and short dollar exposure to neutralize market movements.
• EMN funds actively rebalance long and short weights to maintain low beta, accepting steadier but typically smaller returns.
• Long–short funds with a bias may let winners run and use leverage to amplify returns, resulting in higher return volatility.
• EMN strategies often appeal to investors seeking low-correlation returns with controlled downside relative to more aggressive long–short approaches.

Example: Pair trading

Pair trading is a common long–short tactic that offsets a long position with a short position in a related stock to exploit relative performance differences.

Example:
– Buy 1,000 shares of Stock A at $33 = $33,000 long.
– Short 1,500 shares of Stock B at $22 = $33,000 short (equal dollar exposure).
– If Stock A rises to $35 (+$2 × 1,000 = +$2,000) and Stock B falls to $21 (+$1 × 1,500 = +$1,500), total profit = $3,500.
– If Stock B instead rises to $23 (loss of $1,500) while Stock A gains $2,000, net profit = $500.

Because sector-wide factors often move stocks together, managers sometimes pair across different sectors (for example, short interest-sensitive utilities while going long defensive healthcare) to reduce common-mode risk.

Advantages

• Ability to profit in rising and falling markets.
• Potentially lower market beta and reduced correlation with broad indices.
• Flexibility to target specific inefficiencies across sectors, regions, and styles.
• Portfolio diversification when added to long-only allocations.

Risks and challenges

• Shorting costs: borrow fees, margin requirements, and potential unlimited loss on individual shorts.
• Short squeezes and rapid repricing can cause large losses.
• Identifying reliable short ideas is typically harder than finding longs.
• Leverage and concentrated positions increase volatility and downside.
• Operational complexity: active rebalancing, short availability, and liquidity constraints.

Practical considerations

• Strategy is most often implemented by experienced managers or hedge funds with resources to research, borrow stock, and manage leverage.
• Fees and trading costs can be higher than for passive strategies.
• Investors should assess manager track record, risk controls, liquidity, and counterparty arrangements before investing.

Bottom line

Long–short equity offers a flexible approach to capture returns from both winners and losers while reducing pure market exposure. Variations range from long-biased (e.g., 130/30) to strictly market-neutral, and implementations include pair trades and sector-rotation tactics. The strategy can enhance diversification and risk-adjusted returns but requires careful management of short-related risks, leverage, and costs.