LONG SHORT EQUITY STRATEGY
/Daniel Sheldon – Scotland
The main strategy used by hedge funds is long/short equities. The aim of this strategy is to take long position on stocks undervalued and to short sell overvalued stocks. Investors assume then that the undervalued stock is going to grow and that the overvalued stock will fall. The main purpose of this strategy is to hedge against the evolution of the market.
There are three sub strategies of long short equity. Indeed, if the amount of long position equals the amount of short position then the position is considered as “market neutral”. The goal in market neutral is to have an exposition close to 0. But it’s hard to maintain a neutral position because long positions tend to gain more and more value whereas short positions tend to loose value. Then, the position is not neutral anymore. So to maintain a neutral position you always have to rebalance the portfolio.
Another sub strategy consists of maintaining a net short exposure to the market, and is called dedicate short. A dedicated short bias strategy aims to make profits when the market declines.
On the contrary, long biased strategy will then describe the sub strategy where the amount of long positions is bigger than the amount of short positions. Thus, the long bias strategy enables the funds to take advantage of increases in the market.
Therefore, long/short equity strategy is really link to the market because if the market falls, stocks will loose value anyways. Investors are taking bets about the evolution of the stock by using stock picking, but they can’t predict the exact evolution of the market. The long short equity strategy is indeed closely linked to the market, with a correlation of 0,762. But the correlation rises higher in time of financial distress.
This strategy is then risky, because investors must correctly predict the evolution and the performance of the stocks, but they also have a risk of “beta mismatch”. The “beta mismatch” refers to the fact that when the market falls sharply, the long positions usually lose more than the short ones. So, even if the long/short strategy is a hedge strategy, it’s still a riskless strategy because it’s really hard to maintain an exposition close to 0.
Long/short equity funds generate profit by, on one hand the return of the market exposure, measured by beta, and on the other hand, the value-added from stock picking, measured by alpha.