Long-Short Equity (L/S) – Guide to Understanding Long-Short Equity Investing

Investors seek portfolio robustness as inflation, Central Bank policies, and other issues cause market volatility. Since the key components of long-short equity strategies mitigate risk, now is an ideal time to explore them.

As the name implies, long-short equity strategies make long and short investments in publicly traded stocks and equity-related derivatives. Long short equity investing strategies exhibit reduced beta, volatility, and drawdown sensitivity to stock market changes compared to long-only strategies.

This article will help you understand this concept better by explaining the nuances, including regulatory considerations for long short equity investing.

Long-short Equity Investing

The long-short equity investing strategy allows hedge funds and mutual fund managers to reduce investment risk during down markets. Combining short and long positions together can assist private investors in creating a portfolio less associated with public market fluctuations.

What exactly is long-short equity? Let’s see.

What is Long-short Equity Investing?

In long-short equity investing, hedge funds and mutual fund managers buy equities. An investor attempts to profit from a fall in stock value by shorting. To achieve that, they can sell the borrowed stock in their margin account, buy it back when the price drops, and then return the purchased shares to the lender.

The fund’s profitability is possible during bull and declining markets due to its long and short positions. This hedging approach or absolute return investing seeks returns independent of market conditions.

It is common practice for investment managers to seek out inexpensive companies and sell them when they become too expensive. If the portfolio’s holdings of affordable companies rise and those of overpriced equities fall, the portfolio stands to gain over time.

How does Long-short Equity Investing work?

The term “long-short equity strategy” describes portfolios that combine long and short positions to take advantage of price increases and decreases in the market. Long-short equity investing aims to profit from the potential gains of specific assets while limiting their losses.

• “Long” positions include buying stocks with the expectation that their value will increase to profit from growth.
• A “short” position occurs when a brokerage borrows securities and then sells them to repurchase them at a lower price.

Investors who take “long” positions stand to gain when the value of certain stocks rises relative to the market as a whole. When investors anticipate that a stock will underperform the market, they can take a “short” position and benefit when the share price drops. The borrower of the shares must get them back from the short seller before the agreed-upon deadline.

The company creates a portfolio with reduced connection (i.e., lower risk) to the market and particular industries/companies by diversifying it by combining long and short positions.

Example for Long-Short Equity

Consider a practical example of a long-short equity strategy using fictional stocks, Company X and Company Y.

Key Takeaways

• Long-Short Equity aims to profit from both rising and falling stock prices.
• You can gain from long positions if the chosen stocks appreciate as expected.
• You gain from short positions if the chosen stocks depreciate as expected.
• The strategy can potentially mitigate market risk by offsetting losses in one direction with gains in the other.

Types of Long-Short Equity Investing Strategies

Market-neutral and Directional techniques are part of long-short equity investing strategies. Market-neutral strategies limit exposure to market movements, while directional strategies take positions based on market trends and expectations. An investor’s risk appetite, market perspective, and investing goals are the primary factors when deciding between these methods.

• Market Neutral Strategies – Market-neutral long-short equity investing strategies aim to generate returns from stock-specific factors rather than overall market trends. Maintaining a balance between long and short positions, these strategies, such as pair trading and statistical arbitrage, seek a net market exposure close to zero.
• Directional Strategies – During bullish markets, investors adopt larger long positions, expecting appreciation, and during bearish markets, they take larger short positions, anticipating declines. Strategies like trend following, momentum investing, or macroeconomic analysis guide these directional approaches.
• Sector Specific – Sector-specific strategies focus on long and short positions within a particular sector of the economy, such as technology, healthcare, or energy. Investors might go long on stocks within a sector they expect to outperform and short those expected to underperform. The idea is to leverage sector-specific knowledge and trends to gain an advantage.
• Geographic – Geographic strategies involve taking long and short positions based on regional or country-specific trends. An investor might go long on markets or companies in countries expected to experience growth (emerging markets, for example) and short those in countries facing economic downturns. This strategy requires a deep understanding of global economic and geopolitical factors.
• Pair Trading – Pair trading is a strategy that simultaneously enters a long position in one stock and a short position in another highly correlated stock within the same sector. The strategy banks on the idea that the relative prices of these two stocks will converge over time. This convergence can occur regardless of the overall market direction, making it a market-neutral strategy.

Benefits and Risks of Long-Short Equity Investing

Benefits of long-short equity investing strategies include the possibility of risk mitigation. More importantly, as market circumstances change, this approach typically allows for the flexibility to shift one’s risk profile.

Advantages of Long-Short Equity

Long-short equity investing offers numerous advantages, such as:

• Possible returns – Profits may accrue from rising and falling prices using long-short strategies, which do not place as much emphasis on upward markets.
• Portfolio diversification – When managers use long-short investment strategies, they buy stocks they think will do better than the market and sell assets they believe will do worse. As a result, the chances of making money are higher because the portfolio is more diverse and less affected by changes in the stock market.
• Lower Systematic Risks – Investors can reduce their portfolio’s sensitivity to market fluctuations by combining long and short positions.
• Flexibility – Long-short strategies allow managers to adjust risk profiles based on market conditions without being tied to a benchmark.

Risks of Long-Short Equity

The assumption that previous performance predicts future outcomes is not always true. Therefore, keep in mind that the following risks await long-short equities investors:

• Market risk – Because of how the market generally moves, there is always a chance of losing money.
• Short-sale – Selling an investment short has the inherent risk of suffering large losses due to stock market gains.
• Highly individualistic – Another potential source of loss is issues unique to the business, which are often unrelated to general market trends.
• Higher Expenses – Long-short equity funds usually employ more intricate investment strategies, which can lead to higher expenses.

Factors Influencing Long-Short Equity Investing Strategies

Strategies for long-short equities combine long and short positions simultaneously and rely on important factors. This section looks at how market conditions and macroeconomic factors affect these methods.

Market Conditions

Current market circumstances are crucial to the performance of long-short equity investing strategies. The following are how market conditions affect long short equity investing.

• When market volatility or uncertainty is strong, these tactics can work even better since mispricings and contrasting stock performances are more noticeable.
• Long positions have a better chance of succeeding in bullish markets, while short positions have a better chance of succeeding in negative ones.
• Strategies that work well in one market setting don’t necessarily translate to success in another; being able to adjust to shifting market dynamics is essential.
• If there isn’t enough liquidity, carrying out your plan and getting into or out of situations quickly can be hard.

Macroeconomic Factors

Another important factor influencing long-short equity investing decisions is macroeconomic developments. Let’s see how.

• Various industries and sectors can be affected by macroeconomic variables like inflation, interest rates, and general economic development, affecting how stocks perform.
• As a part of their strategy, long-short equity investors frequently use macroeconomic analysis to foresee economic changes and modify their holdings appropriately.
• If you want to know which industries will boom or bust, you need to know the bigger picture of the economy. Key macroeconomic factors complicate long-short equities decisions, including central bank policy and geopolitical developments.

Implementing Long-Short Equity Investing Strategies

Successful long-short equity investing strategy implementation demands a sophisticated portfolio development and stock selection approach.

Investors frequently choose to go long when they see strong fundamentals and promising development when employing long-short equity investing strategies. For instance, a corporation that experiences diminishing revenues or has overextended valuation ratios may be the subject of a short position.

Financial metrics like price-to-earnings ratios and relative strength indicators can help with decision-making when employing quantitative models to find mispricing. It is essential to achieve balance while building a portfolio. An investor pursuing a market-neutral strategy may seek to reduce their total market exposure by balancing long and short holdings.

Diversification is a strategy that involves spreading your investments out among several industries or stocks to lower your overall portfolio risk. Consider a scenario in which a shareholder shorts a firm in a collapsing industry and takes a long position in a technology stock with room to expand.

Allocating funds according to risk-reward factors and conviction levels is an effective way to size positions. The portfolio remains in sync with evolving market circumstances through consistent monitoring and modifications. Consider an example of a portfolio that dynamically changes its sector weights in response to economic data or company earnings announcements.

Performance Metrics for Long-Short Equity Funds

Here are a few performance metrics to gauge Long short equity investing.

• Alpha – Alpha measures a fund’s excess return compared to its benchmark, indicating the manager’s skill in generating returns above what would be expected given the level of risk taken.
• Beta – Beta measures how much a fund’s returns move with the overall market. Long-short equity funds aim to reduce this by taking both long and short positions.
• Volatility – Volatility measures how much the returns of a fund vary over time. Lower volatility indicates less risk and smoother performance.
• Drawdown – Drawdown is the difference between the highest point of a fund and its lowest point before a new high is reached. Monitoring drawdowns helps evaluate potential losses and risks in a long-short equity strategy.
• Sharpe Ratio – The Sharpe Ratio, a key metric for long-short equity funds, gauges risk-adjusted returns. It measures the excess return per unit of risk, helping investors assess performance relative to volatility. A higher Sharpe Ratio signifies better risk-adjusted returns, aiding in fund comparison and decision-making.
• Tracking Error – This metric is crucial for long-short equity funds, quantifying deviations from a benchmark. A moderate tracking error indicates active management potential for alpha, while excessive deviations may signal unforeseen risks. Assessing tracking error alongside other metrics provides a comprehensive view of a fund’s ability to outperform its benchmark.

Regulatory Considerations for Long-Short Equity Investing

An important factor influencing the execution of long-short equity investing is the regulatory framework in which it works. It is essential to navigate these regulatory issues to protect investor interests, stay in compliance with the law, and keep long-short equity strategies intact.

• Short-selling Regulations – Long-short equity investing strategies include short selling, subject to different market restrictions. Furthermore, authorities may establish regulations to forestall market manipulation, including introducing short-sale pricing tests.
• Compliance and Reporting – Long-short equity funds must adhere to extensive compliance and reporting standards to maintain accountability and transparency. It is critical to adhere to penalties against Anti-money laundering (AML) and know your customer (KYC) laws.
• Insider Trading Regulations – Long-short equity funds must abide by insider trading regulations that differ depending on the jurisdiction.
• Conflict Of Interest – Long-short equity funds must address conflicts of interest that arise from serving dual roles, such as acting as an adviser and a principal to clients.
• Disclosure Requirements – Local regulatory guidelines require long-short equity funds to disclose their full portfolio holdings, including short positions.

Both domestic and international long-short equity funds must comply with these regulations to protect investors and maintain integrity.

Manage your equity on Eqvista!

Some institutional investors use long-short equity investing strategies to get the most out of their portfolios while minimizing their exposure to market risk. They can increase their profits while decreasing risks using derivatives and leverage.

For streamlined equity management that aligns with regulatory standards, consider leveraging platforms like Eqvista. Your long-short equity investing efforts will be more successful if you manage your equities on Eqvista, which will also improve transparency, expedite compliance processes, and help you handle regulatory hurdles more efficiently.

Take charge of your equity management today – Call Eqvista for a personalized demonstration and consultation!