Long-short equity strategy is a type of portfolio management strategy where the manager attempts to minimize market risk by taking both long and short positions. The idea is that if the market declines and the long positions take losses, the short positions will provide gains and minimize overall losses and keep the portfolio profitable.
Let’s go over how the long-short equity strategy works and how you can use it in your own portfolio.
Definition and Examples of a Long-Short Equity Strategy
The long-short equity strategy is an investing strategy used mainly by hedge funds or mutual funds managers to purchase stocks they expect to go up and short stocks they expect to go down. With shorting, an investor tries to earn profits when a stock declines in value. They can do that by selling a stock they’ve borrowed in a margin account, then buying it back after its price has fallen to return to the lender.
With both long and short positions, the fund can potentially earn profits in both bull and bear markets. This concept of trying to make gains regardless of market conditions is also referred to as absolute return investing strategy, or hedging.
Generally, investment managers aim to choose undervalued stocks to buy and overvalued stocks to short. Over the long term, the portfolio can profit if the undervalued stocks increase and the overvalued stocks decline.
If a portfolio’s returns are less correlated with broader market movements, the fund is said to be more market neutral.
One example of a fund using a long-short equity strategy can be found with BlackRock, which offers a long-short equity fund called The BlackRock Global Long/Short Equity Fund. The firm uses traditional fundamental analysis to buy and short equities in developed markets. (Read more about BlackRock and other examples of long-short strategies below.)
How a Long-Short Equity Strategy Works
The long-short strategy originated in hedge funds and is now also used with managing mutual funds. It is less common among individual traders. Let’s look at a few examples of how the strategy works.
For example, BlackRock offers a long-short equity fund called The BlackRock Global Long/Short Equity Fund that uses traditional fundamental analysis to pick long and short positions in global equities. The fund aims to minimize volatility with diversification. It also aims to minimize net exposure to the market by using various hedging strategies that focus on sectors, geographies, and market neutrality.
Another example is the Guggenheim Long Short Equity fund, like many hedge funds this fund uses leverage to amplify returns. It invests with long and short positions in several sectors, including utilities, financials, consumers, and real estate.
A long-short equity strategy commonly used by hedge funds is called the 130-30 equity strategy, which favors long positions. Essentially, the fund invests 130% of its capital in long positions by getting that 30% from shorting.
What It Means for Individual Investors
A long-short equity strategy has several pros and cons to consider. Balancing long and short strategies can help investors develop a portfolio that is less correlated with market movements. So, they have the opportunity to earn gains that beat the broader market.
However, while this investing strategy can help minimize risk, it cannot eliminate all risk.
Individual investors considering long-short equity funds should consider their fees, which tend to be higher than an average mutual fund. Higher fees, of course, can affect your profits.
For example, the Guggenheim Long Short Equity fund charges a gross expense ratio of 1.75%, compared to an average of about 0.54% for the mutual fund industry, according to Vanguard (which did not include its own funds).
The higher expense ratio with many long-short funds is due in part to the higher costs from leveraging, shorting, and more frequent trading in the funds.
Still, long-short mutual funds have a lower barrier to entry than a hedge fund, which may require more than $100,000. Long-short mutual funds, in contrast, often require $1,000 or less to invest.
Finally, experienced individual investors can also try their own form of a long-short strategy by using pairs trading, although keep in mind that this is an advanced trading strategy. Pairs trading is the practice of going long and short a stock in the same industry or sector. That way, a market drop would affect both positions.
- Long-short equity investing is the strategy of buying and shorting stocks to reduce market risk and maximize returns in a portfolio.
- By shorting stocks as well as buying them, the portfolio has the potential to increase, even in a down market.
- Many mutual funds employ a long-short strategy, but investors should consider their higher fees.