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Equity Long/Short - A Two-edged Sword

Equity long/short strategy is a strategy through which a fund manager buys undervalued stocks which are expected to outperform, and short sells overvalued stocks which are expected to underperform. This type of portfolio is sometimes called “market neutral”, although strictly speaking a market neutral portfolio is achieved only if the long exposure balances the short exposure so as to eliminate systemic market risk. Some market neutral funds even go one step further to eradicate industry risk by making pair-wise bets within each sector, but such an objective can only be achieved if strict risk controls are kept constantly in place. Market neutral portfolios are perceived to be a lower risk type of hedge fund. In reality, however, most equity long/short funds tend to range between a slightly net short position to 100% net long, depending on whether the manager is bullish or bearish on the market, although recently some have widened those ranges.

The beauty of an equity long/short strategy is that it can fully take advantage of the fund managers’ stock picking capabilities. Note that the end-result of the fund managers’ stock research is the identification of winning stocks ie. the buy candidates. On the flip side, those stocks which fail this test are identified as the losing stocks and could become the short candidates. In other words, alpha1 can potentially be generated from both the long and the short sides, as opposed to a traditional long-only fund where alpha is generated from the buy side only.

In order to profit from a long/short strategy, the short picks need not necessarily drop or the long picks need not necessarily rise – it will be profitable as long as the long picks outperform the short picks so that a positive spread can be pocketed. Of course, if everything goes against the fund manager and those stocks which constitute his long positions underperform, while those stocks which he shorts outperform, it will be a double whammy.

Some equity long/short managers may employ leverage to gear their stock bets if they have a very strong conviction in their stock selections. The logic behind this is that a long/short fund can buy more good stocks without taking as much risk as a fund which merely buys and does not short. With the added dimension of downside risk management through the shorts, one can be bolder in pursuing stocks with strong appreciation potential. This could potentially increase the fund’s return while minimising broad market risk, but stock-specific risk will increase in this case.

The ability to short individual stocks is often limited in less developed markets and among smaller stocks, either due to low liquidity, regulatory restrictions or lack of suitable instruments. Paradoxically, these are often the areas with the least market efficiency and hence the biggest opportunity to generate alpha. In that case, how can we “neutralise” our long positions or exploit the pricing anomalies on the short side? Fund managers may hedge overall market exposure through selling the broad market indices in the futures market or buying put options. If these are not available either, then proxies such as ADR/GDRs (American Depositary Receipts and Global Depositary Receipts) trading in other markets, OTC (over-the-counter) derivatives or exchange traded unit trusts could be valuable tools. However, you must be careful to distinguish between aggressive, speculative hedge funds that make highly leveraged directional bets using derivatives and those that use derivatives primarily to hedge downside risks. Bear in mind that while the maximum you can lose on a long position is your invested capital, there is no ceiling on how much you can lose on a short position as there is no limit as to how high a stock can go. That is why risk control is so important in hedge fund management.

Equity long/short strategy is most valuable when there is a big divergence of performance across stocks (of course that hinges on the fund manager’s ability to identify those winners and losers), or when broad market volatility is high. In the first case, such a strategy could produce superior returns even if the average market performance is flat (ie. with rising stocks offsetting declining ones). In the latter case, a long/short approach should be able to provide much smoother returns than the general market. In this sense, it can serve to enhance returns and/or reduce volatility to produce a better risk-adjusted return.




The above information is shown for illustrative purposes only. It is not intended and should not be interpreted as the performance of an actual investment.

An equity long/short strategy can also help cushion the downside during a bear market. But of course, everything comes with a price as this strategy typically underperforms the traditional long-only approach during a bull market. Given its low correlation with traditional asset classes, this type of fund is classified under “alternative investment” in the investment universe. Investors should consider buying such hedge funds to enhance the risk/return profile of their existing portfolios, ie. to get “more dollar bang for each risk buck”. Allocation can be adjusted between equities, bonds, cash and hedge funds to arrive at your desired level of risk, while maximising your potential return. Depending on your objectives and risk tolerance, in general we recommend an allocation between 5-15% to hedge funds.

As opposed to a long-only fund whose return is derived more from broad market movement than manager skills, an equity long/short fund relies largely on the manager’s stock picking capabilities. Therefore, in choosing which equity long/short fund to buy, investors should pay attention to the fund manager’s research resources, investment process, risk control, experience and consistency of performance. This can help discern real expertise from pure luck. If you have a chance, try to check upon the fund manager’s performance attribution reports to unveil his strengths and weaknesses (ie. where he has added or lost value). An analysis of his stock rankings would definitely help too.

For example, at JF Asset Management we constantly run performance analyses of the stocks our fund managers rank in each market. We have a ranking system of 1 to 5, with 1 being those stocks which we like most and 5 being those we most dislike. We then look at the aggregate performance of those stocks of the same rank to see if they outperform or underperform over time as expected. The following chart for the Hong Kong stock market confirms that JF Asset Management has been able to identify both the winning and the losing stocks in a consistent manner. This is exactly the type of managers that you should look for.

Click here for a larger image

Source: JFAM (with monthly rebalancing)

* Discontinued between 12/03 and 3/04 as there were no 5-ranked stocks during that period

Alpha refers to the extra return above the broad market return and is typically used to measure a fund manager’s value added.