Long-Short Equity Strategy: A Comprehensive Guide

The long short equity strategy involves taking both long and short positions in various equities, a tactic commonly utilised by hedge funds to enhance risk adjusted returns given its inherently lower risk profile. ⁽¹⁾

In this guide, we delve into the mechanics of this strategy, exploring its implementation and backtesting results using Python. We'll cover the basics such as the historical context, and the sources driving its returns, as well as the advanced topics such as its comparison with other investment approaches like long-only and market-neutral strategies.

Additionally, we'll address common myths surrounding the strategy and provide step-by-step guidance on building and implementing it effectively. From understanding the ranking scheme and capital allocation to managing risk and transaction costs, this comprehensive guide offers insights into the nuances of long-short equity investing, highlighting its pros and cons.

This blog covers:

• What is a long short equity strategy?
• Types of long short equity funds
• Long short equity strategy vs long only investing
• Long short equity strategy vs market neutral strategy
• Long short equity strategy vs value investing
• Working of the long short equity strategy
• Myths about long short equity strategy
• Steps to build a long short equity strategy
• Steps to build a long short equity strategy in Python
• Ranking scheme for the long short equity strategy
• Capital allocation for the long short equity strategy
• Rebalancing frequency for the long short equity strategy
• Risk management and industry trends
• Transaction costs and slippages of the long short equity strategy
• Application of long short equity strategy
• Pros of long short equity strategy
• Cons of long short equity strategy

What is a long short equity strategy?

The long-short equity strategy involves buying the stocks expected to rise (long positions) and selling the stocks expected to fall (short positions). It aims to gain from both market upswings and downturns while minimising overall market exposure.

Example of long-short equity strategy

An example of a long-short equity strategy involves simultaneously buying shares of undervalued companies (going long) while selling shares of overvalued companies (going short).

For instance, suppose an investor identifies Company A as undervalued and Company B as overvalued based on fundamental analysis. They would buy shares of Company A with the expectation that its stock price will increase (long position) and sell shares of Company B with the anticipation that its stock price will decline (short position).

By maintaining a balanced portfolio of long and short positions, this strategy allows traders to potentially generate returns regardless of whether the broader market is trending up or down.

Let us see some real life examples of undervalued stocks and overvalued stocks which can be included in the long short equity strategy.

In Jan-March 2024, below is the list of overvalued and undervalued stocks.

Top 5 Most Overvalued Stocks

Top 5 Most Undervalued Stocks

Now, let us see how long short equity strategy came into existence.

History of long short equity strategy

The history of long short equity strategy dates back to the 20th century with the rise of the hedge funds since this strategy is most commonly deployed in hedge funds. Let us see below how this strategy came into existence gradually with the milestones mentioned.

20th century - Rise of hedge funds
The history of the long-short equity strategy dates back to the early 20th century when investors began employing techniques to mitigate market risk while capitalising on individual stock movements. However, the strategy gained prominence in the latter half of the 20th century with the rise of hedge funds and institutional investors.

1950s and 1960s - Value investing began
In the 1950s and 1960s, investors such as Benjamin Graham and Warren Buffett popularised value investing, a fundamental principle underlying the long-short equity strategy. They advocated for buying undervalued stocks and short selling overvalued ones to profit from discrepancies in market pricing.

1970s and 1980s - Emergence of long short equity strategies
During the 1970s and 1980s, advancements in financial theory and computing technology facilitated the implementation of more sophisticated quantitative models for stock selection and portfolio management. This period saw the emergence of quantitatively-driven long-short equity strategies, leveraging statistical analysis and mathematical algorithms to identify profitable opportunities.

Late 20th century and early 21st century
In the late 20th and early 21st centuries, regulatory changes, increased competition, and the proliferation of financial instruments further shaped the landscape of long-short equity investing. Today, the strategy continues to evolve with developments in data analytics, machine learning, and artificial intelligence, enabling investors to refine their approaches and adapt to changing market conditions. ⁽²⁾

Next you will see the sources of strategy returns.

Sources of strategy returns

The returns generated by a long short equity strategy stem from mainly the following sources:

• Stock Selection: Profits are derived from correctly identifying undervalued stocks for long positions and overvalued stocks for short positions. Skilled analysis of company fundamentals, financial metrics, and market sentiment contributes to effective stock selection.
• Market Timing: Successfully timing the market can enhance returns by entering long positions during periods of market upswings and short positions during downturns. However, market timing requires astute observation of economic indicators, technical analysis, and macroeconomic trends.
• Factor Exposures: Long-short equity strategies often incorporate exposure to specific factors such as value, growth, momentum, or quality. Capitalising on these factors' performance relative to the broader market can drive returns.

Now that you understand the basics of long short equity strategy, let us move forward and find out the types of long short equity fund.

Types of long short equity funds

Long-short equity funds come in various types, each with distinct characteristics and investment strategies tailored to specific market conditions and investor preferences. A few common and popular types are: ⁽²⁾

• Sector-specific funds: Sector-specific long-short equity funds focus on specific industries or sectors, such as technology, healthcare, or financials. These funds employ deep industry expertise to identify opportunities for both long and short positions within the chosen sector.
• Market-neutral funds: These funds aim to achieve zero net market exposure by equally weighting long and short positions. Market-neutral strategies focus on exploiting relative mispricing between long and short positions rather than directional market movements.
• Geographic funds: There are geographical long-short equity funds that focus on specific regions or countries, such as the United States, Europe, Asia, or emerging markets. These funds employ a long-short investment strategy within a particular geographic area, allowing investors to capitalise on local market opportunities while mitigating overall market risk through short positions.

Moving forward, we will see the differences between long short equity strategy and long-only investing.

Long short equity strategy vs long-only investing

There is a considerable difference between long short equity strategy and market neutral strategy as well which we will see next.

Long short equity strategy vs market neutral strategy

There is one more term that is widely used in trading, that is, value investing which also takes into consideration the overvalued and undervalued stocks. Let us find out how long short equity strategy is different from value investing.

Long short equity strategy vs value investing

Going forward, we will see the working of the long short equity strategy.

Working of the long short equity strategy

To understand the workings of this strategy let’s take a look at an example. A hedge fund takes a $1000 long position each in Apple and Google, and a $1000 short position each in Microsoft and IBM.

                           Portfolio (Technology Sector)

For an event that causes all the stocks in the technology sector to fall, the hedge fund will have losses from long positions in Apple and Google but will have profit from short positions in Microsoft and IBM.

Thus, there will be minimal impact on the portfolio. Similarly, an event that causes all the stocks in the technology sector to rise will also have minimal impact on the portfolio. The hedge fund took this position because they expected Apple and Google’s share prices to rise and Microsoft and IBM’s share prices to fall.

If the view of a fund manager is biased towards the long side, then he can give more weight to the long side of the portfolio such as 70% of the capital to the long side and 30% of the capital to the short side.

However, the impact of the market crash on the portfolio will be higher. But such a construct with a higher proportion in long positions would help the portfolio value to appreciate faster in the bull run, like the one seen after the fall due to COVID-19.

There are certain myths surrounding the long short equity strategy that you must know.

Myths about long short equity strategy

Several myths surround the long-short equity strategy, often clouding investors' perceptions. Let us see these myths below.

1. One common misconception is that it's a risky strategy due to its short-selling component. However, when executed properly, long-short equity can offer risk-adjusted returns.
2. Another myth is that it requires complex mathematical models. In reality, successful implementation relies more on fundamental analysis and market understanding than sophisticated formulas.
3. Additionally, some believe that long-short equity is only suitable for hedge funds, but individual investors can also benefit from its principles with appropriate risk management.

The steps to building a long short equity strategy will be discussed next.

Steps to build a long short equity strategy

A long short equity strategy is built with the following steps:

Let's learn about each step in detail and create our own long short equity strategy.

Step 1 - Define the Universe

Identify a universe of stocks in which we will take positions. The universe can be defined based on dollar-volume, market capitalisation, price, and impact costs. Here, we will use market capitalisation to identify our stocks.

Step 2 - Bucketing stock

From the universe of stocks, we will bucket stocks based on the sector such as technology, pharmaceuticals, automobiles, financial services, and FMCG. For our example, we will be using the technology sector.

Step 3 - Define parameter to long or short security

This is the key step in the workflow. Here we will rank stocks in the bucket based on the previous day’s returns. Stocks that have performed well will be ranked higher and stocks that performed poorly will be ranked lower.  We will use the principle of mean reversion to take our trades. We will go long on stocks with the lower rank and go short on the stocks with the higher rank.

Note: A combination of parameters such as quarterly earnings growth, PE ratio, P/BV, moving averages, and RSI could be used here with different weights on each parameter to create a profitable strategy.

Step 4 - Capital allocation

Allocating an equal amount of capital to each stock shortlisted from step 3 is a popular capital allocation strategy. An equal weight approach helps to avoid a concentration on a particular stock in the portfolio.

Let us now see the calculation part in the long short equity strategy with Python.

Steps to build a Long short equity strategy in Python

First, let’s start with importing all the necessary libraries. We will be using the yfinance library to import our data. For this strategy, we have selected a bunch of 38 large-cap tech stocks listed on the NYSE.

Step 1 - Import libraries and fetch historical data

Step 2 - Calculate returns

Step 3 - Generating signals

Output:

Step 4 -  Print cumulative returns, sharpe ratio and maximum drawdown

Output:

Cumulative Returns:
1.0314663731001577

Sharpe Ratio:
0.0038672646408557058

Max Drawdown:
-0.03183340726727493

Step 5 - Visualisation

Output:

From the above plots, it can be seen that the strategy yielded a modest positive return with a relatively low risk-adjusted performance, as indicated by the Sharpe Ratio. Additionally, the maximum drawdown was moderate, suggesting some degree of volatility in the strategy's performance.

It is important to note that backtesting results do not guarantee future performance. The presented strategy results are intended solely for educational purposes and should not be interpreted as investment advice. A comprehensive evaluation of the strategy across multiple parameters is necessary to assess its effectiveness.

Now, let us see the importance and role of the ranking scheme in long short equity strategy.

Ranking scheme for the long short equity strategy

The choice of ranking scheme is the most critical component of this strategy. In our example, we used a 1-day return to rank our stocks. Such a technical factor can be coupled with other indicators like moving averages, volume measures, etc.

It is also a very important decision whether to use momentum or mean reversion when ranking the stocks as different stocks would have different behaviours.

Another popular strategy is to use fundamental factors like the value and performance of the firms using a combination of P/E ratio, P/B ratio, profit margins, earnings growth, and other fundamental factors to come up with a ranking scheme.

For example, the QMJ(Quality Minus Junk) portfolio of the AQR capital management company, ranks its stocks based on a quality score. This quality score is formed by combining three fundamental factors: profitability, growth and safety.

We will discuss the relevance of choosing the capital allocation for the long short equity strategy next.

Capital allocation for the long short equity strategy

Once the ranking process is completed, the allocation of capital across stocks becomes crucial for the strategy's performance. In our approach, we utilised the equal-weighted method, allocating the same weight to all stocks.

Alternatively, weights could be assigned based on daily returns, giving higher weights to stocks deviating more from average returns. Another common method is market capitalisation based weighting, which reduces exposure to volatile small-cap firms.

Rebalancing the frequency plays an important role in the long short equity strategy and we will see that next.

Rebalancing frequency for the long short equity strategy

It is important to determine the period over which a particular strategy will give results. For example, since we were using price data, we were able to predict only for the next day accurately. Nevertheless, we can definitely predict multiple days’ returns based on price data, but the accuracy will not be as high as compared to choosing fundamental factors for predicting weekly or monthly returns.

The rebalancing frequency has an impact on transaction costs but at the same time it is slow in reacting to adverse movements in some portfolio stocks.

Next we will see the risk management and industry trends in long short equity strategy.

Risk management and industry trends for the long short equity strategy

As with all strategies, this strategy also comes with risk. The risk lies in the deviation of the performance of the stocks selected in the portfolio from the expectation.

In the above example, if the securities on the long side see a fall in price and the securities on the short side see price rise, then the portfolio will suffer losses. Prudent risk management is required such as squaring of the stocks on hitting stop loss and keeping profit cap at the individual stock level.

Apart from this, the portfolio must be reconstructed with fresh stocks at regular intervals and the portfolio must hold a large number of stocks. This will help to limit concentration on a stock. A typical sector exposure and the top 5 long short holding of AQR long-short fund is shown below. As you can see the fund is highly diversified with limited exposure to any particular sector.

Similarly, instead of taking large concentrated holding in a particular stock, it holds small quantities of different stocks in order to avoid exposure to company specific risks. Also it can be seen that overall the portfolio is somewhat market-neutral with a slight bias towards the long side. This is in fact a latest industry trend, where more and more hedge funds are biased towards the long side to capitalise on rising equity markets.

Another important concept in long short equity strategy is that of transaction costs and slippages which we will see next.

Transaction costs and slippages of the long short equity strategy

Like any algorithmic trading strategy, for practical application, one must take into account the transaction costs that might come associated with it. Often strategies that might seem profitable might not be once you take into account the transaction costs and slippages.

Since in our strategy, we are taking new trades daily, there would be a large number of trades and hence a significant amount of transaction costs. On the other hand, trades taken based on fundamental factors would be over a month or a quarter and hence, there will be a lesser number of trades and lower transaction costs.

Slippage denotes the variance between the anticipated and actual execution prices of a trade. It can arise from several factors like market volatility, limited liquidity, or substantial trade volumes. The impact of slippage on a trading strategy's overall profitability can be significant, especially in scenarios involving frequent trading or large transactions.

For instance, if a strategy is initially tested assuming a slippage and transaction cost of 0.1% per trade, but subsequent cost analysis reveals higher costs, adjustments may be necessary. Modifying the assumed transaction and slippage costs to 0.2% during strategy testing and development ensures more realistic and accurate backtest results. This adjustment enables traders to account for actual market conditions, thereby enhancing the reliability of their strategies. ⁽³⁾

The transaction costs cost depends on the particular broker's commissions. Each broker charges a different transaction cost. For example, AmeriTrade charges a commission and a spread-based cost in Forex, while Interactive Brokers don't charge spread-based, they only charge a commission.

If there are two brokers who charge only commission-based cost or spread based cost, they will have different values for that commission or the spread. These costs should be evaluated by the trader carefully before proceeding. Hence, it's the trader's responsibility to find out the transaction cost values that the broker charges.

Let us find out the applications of long short equity strategy now.

Application of long short equity strategy

The long-short equity strategy finds broad application across various investment contexts. It is commonly employed by hedge funds, institutional investors, and individual traders seeking to capitalise on both bullish and bearish market conditions. This strategy is utilised for portfolio diversification, risk management, and enhancing risk-adjusted returns. Moreover, long-short equity strategies are applied in sectors ranging from equities and derivatives to alternative investments, including commodities and currencies.

Additionally, this approach can be tailored to specific investment mandates, such as targeting alpha generation, managing volatility, or implementing market-neutral strategies. Overall, the versatility and adaptability of the long-short equity strategy make it a valuable tool in the investment toolkit across different market environments and investor objectives.

There are some advantages which we will briefly discuss next concerning the long short equity strategy.

Pros of long short equity strategy

Below are some of the most useful pros of long short equity strategy.

• Diversification: Offers diversification benefits by simultaneously taking long and short positions, reducing overall portfolio risk.
• Flexibility: Adaptable to various market conditions, allowing investors to profit from both upward and downward price movements.
• Alpha Generation: Potential for generating alpha through skillful stock selection and active management of long and short positions.
• Risk Management: Provides a hedge against market downturns by profiting from short positions during bear markets.
• Customisation: Can be customised to suit specific risk-return objectives and investment mandates.

Let us see some cons to be wary of while using the long short equity strategy.

Cons of long short equity strategy

These are some of the cons of long short equity strategy. You can see the same below.

• Complexity: Requires sophisticated analysis and expertise to identify undervalued and overvalued securities for effective implementation.
• Execution Risk: Execution risk associated with short selling, including potential short squeezes and borrowing costs.
• Leverage: Leverage may be utilised to amplify returns, but it also increases risk and volatility.
• Market Exposure: Long bias or short bias may expose the portfolio to market directional risks.
• Costs: Higher transaction costs, including borrowing costs for short positions, may impact overall returns.

Conclusion

The long-short equity strategy, popular among hedge funds, offers a balanced approach to capitalising on market movements. By simultaneously taking long and short positions in equities, investors aim to enhance risk-adjusted returns while minimising overall market exposure. This strategy, rooted in historical trends and financial theory, has evolved with advancements in technology and regulatory changes. Its returns stem from stock selection, market timing, and factor exposures.

Various types of long-short equity funds cater to diverse market conditions and investor preferences, from sector-specific to market-neutral approaches. Despite misconceptions, successful implementation doesn't necessarily rely on complex mathematical models and is not exclusive to hedge funds. Building a long-short equity strategy involves defining the universe, ranking securities, allocating capital, and managing risk. Key considerations include the ranking scheme, capital allocation, rebalancing frequency, risk management, and transaction costs.

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Author: Chainika Thakar (Originally written by Ishan Shah and Aaryaman Gupta)

Note: The original post has been revamped on 17^th April 2024 for recentness, and accuracy.

Disclaimer: All investments and trading in the stock market involve risk. Any decision to place trades in the financial markets, including trading in stock or options or other financial instruments is a personal decision that should only be made after thorough research, including a personal risk and financial assessment and the engagement of professional assistance to the extent you believe necessary. The trading strategies or related information mentioned in this article is for informational purposes only.