What is Long Short Equity?

Investors use many different strategies to earn money through the stock market. One method, long-short equity, sounds complex but is easy to understand in theory. Many hedge funds and mutual fund managers use long-short equity strategies to maximize their earnings, even during bear market periods.

Understanding Long-Short Equity

A long-short equity strategy involves buying a combination of stocks held for both the long and short term.

The value of long-term investments is expected to appreciate over time, but it may take a while to realize a significant return. The investor holds another portion of stocks for which they expect the value to decline.

For the long-short equity strategy to work, the investor borrows the targeted short stocks on margin, then replaces them with the depreciated stock they buy. As a result, they can earn a profit.

The long-short equity strategy helps with portfolio diversification. Investors can diversify their long and short holdings in percentages, like 80% long and 20% short. Most investors who follow the strategy emphasize long holdings over short ones since the general trend of the stock market over the past few years has been upward.

Like any investment strategy, there are risks in long-short equity positions. For starters, there’s no guarantee that a stock will swing one way or another.

A stock held for long-term gains could lose value, eliminating profits from short positions. Similarly, a stock bought on margin could increase in value, resulting in a loss to the investor who anticipated a decline and now needs to repay the brokerage with a more costly stock.

However, there are also several benefits to the long-short equity strategy. It helps to mitigate the systemic risk that all investors are exposed to. Since the investor takes both a long and a short approach, they should realize gains over their long-term holdings. They should also limit their losses if the market takes a sudden unexpected downturn. 

Long-short equity can also help to maximize profits from investing. The investor profits on both gains and losses, achieving greater earnings than if they had invested in growth alone.

How Long-Short Equity Works

A long-short equity strategy requires research and technical knowledge.

The investor must identify the stocks they feel aren’t correctly priced. Undervalued stocks are ripe for a long position, while overpriced stocks are ideal for shorts. Fundamental analysis can help uncover mispriced securities, but there are no guarantees of accuracy.

There are two general types of fundamental analysis: top-down and bottom-up.

Once the fundamental analysis is complete, the investor should have a list of securities they believe are mispriced. They can then decide how to allocate their holdings among portfolio weights. For instance, they might invest 25% of their available money in shorts and 75% in longs. 

After the investor settles on their allocation and makes the appropriate trades, they must monitor their portfolio carefully. Most investors set a certain percentage of losses they’re willing to accept before they give up their holdings. That way, they prevent unexpected losses that could be severely detrimental to their investment strategy.

Example of the Long-Short Equity Strategy

As an example, consider an investor who performs fundamental analysis to identify mispriced stocks.

They determine that Alphabet’s current stock price of $100 is undervalued, while Meta’s stock price of $50 is overvalued. They take a 70/30 long-short allocation, buying seven shares in Alphabet and borrowing six in Meta on margin. 

Over the next month, Alphabet’s share price rises to $150, and Meta’s falls to $40. The investor decides to dispose of both stocks.

Alphabet’s share-price gain results in $350 in profits (7 shares x $50 share increase), while the decline in Meta results in a $60 profit (6 shares x $10 loss). In total, the long-short equity strategy yields $410 in profits.

Does Long-Short Equity Investing Hedge Risk?

Long-short equity strategies can help hedge risks for investors in several ways.

• Market risk: Market risk is inherent to all investments. It can occur anytime the economy undergoes a significant shock. Since the long-short equity strategy includes short positions for market losses, it’s efficient for hedging against unexpected economic downturns caused by macroeconomic shocks.
• Leverage risk: Leverage risk involves borrowing too much money for stocks in anticipation of a decline in their value. While long-short equity requires the investor to borrow on their short positions, the losses they incur will be offset by the gains on long holdings if the strategy plays out.
• Company-specific risks: A long-short equity can hedge against company-specific risk since the investor will simultaneously take positions in several different organizations rather than a single business.
• Sector/Industry risks: To hedge against specific sector or industry risks, a long-short strategy should combine stocks from several market sectors, not just one.

Long-Short Equity vs. Equity Market-Neutral Strategies

Long-short equity and equity market-neutral strategies share some characteristics, but they differ slightly.

In an equity market-neutral strategy, the investor takes a roughly equal position in both their long and short holdings, for instance, 50% in short and 50% in long positions. The strategy also requires that the selected investments share certain characteristics — they may be in the same market sector or industry or have historical correlations.

An equity market-neutral position isn’t easy to manage. It requires regular rebalancing to ensure that the portfolio maintains its equality in both long and short holdings. For instance, if a market trend emerges that pushes its long positions ahead, it will need to leverage against losses by allocating more toward shorts.

By contrast, the long-short equity strategy doesn’t aim for equal proportions in long and short holdings. A long-short equity can also involve a mixture of investments across different market sectors for additional diversification.

Key Considerations for Long-Short Equity Investors

Investors interested in a long-short equity strategy can attempt to manage it independently, but they’ll probably see optimal returns by entrusting their money to an experienced financial adviser.

When selecting an investment manager, it’s crucial to perform due diligence. Ask about their experience handling a long-short equity strategy and request to see prior results.

Market conditions can impact your profits from a long-short equity strategy. If the market suddenly takes a turn for the worse, your short holdings should mitigate some of the losses you experience from your long positions. Portfolios with a higher percentage of short holdings will fare better if the market declines.

Diversification of your long-short equity portfolio, including holdings across different market sectors, industries and geographies, can help mitigate the losses you experience.

Of course, no investment strategy can completely hedge against risk, as investing always carries some chance of losses. Make sure you’re comfortable with the losses you experience, and do your best to mitigate them before going forward with a long-short equity strategy.

Long-Short Equity Strategies Can Help Manage Market Risk

A long-short equity strategy is popular among mutual fund investors and hedge funds. Individual investors can attempt the same technique, but unless they’re professionals, they likely won’t have access to the resources that a dedicated investment firm will.

As with all investment strategies, long-short equity carries some risks, but it can help protect against unexpected changes in the market.

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