By Ishan Shah
Long-short Equity Strategy is the most common strategy used by a hedge fund. In this strategy, half of the capital is deployed to take a long position in a set of undervalued securities and another half to take short positions in a set of overvalued securities. The rationale is that the long positions are expected to increase in value whereas short positions are expected to decrease in value.
A portfolio constructed in this fashion helps to protect from losses during the market crash. Therefore, this strategy is known as market-neutral strategy.
A more sophisticated way to construct this portfolio is to deploy equal amount of money in long positions and short positions within each sector to form a sector-neutral portfolio. This approach will help protect the performance of the portfolio from price fall in any of the sector and makes portfolio less volatile.
Let’s look at an example. A hedge fund takes a $1000 long position each in Apple and Google and $1000 short position each in Microsoft and IBM.
For an event which 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 which 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 he or she expects Apple and Google share price to rise and Microsoft and IBM share price to fall.
If the view of a fund manager is biased towards a 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.
How to build the strategy
A long-short strategy is built as follows:
- Define Universe: Identify a universe of stocks in which we will take positions. The universe can be defined based on dollar-volume, market capitalization, price and impact cost.
- Bucketing stock: From the universe of stocks, we will bucket stocks based on the sector such technology, pharmaceuticals, automobiles, financial services, and FMCG.
- Define parameter to long or short security: This is the key step in the workflow. Here, for each bucket defined in step 2, we will rank stocks in the bucket based on previous quarter earnings. Stocks with good earnings growth will be ranked higher and stocks with negative earnings will be ranked lower. Then, we will go long on 5 stocks with higher rank and go short on 5 stocks with lower rank. Note: A combination of parameters such as PE ratio, P/BV, moving averages and RSI should be used here with different weights on each parameter to create a profitable strategy.
- Capital allocation: We allocate an equal amount of capital to each stock shortlisted from step 3. Equal weight approach helps to avoid a concentration to a particular stock in the portfolio.
As with all strategy, this strategy also comes with risk. The risk lies in 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 a rise in price, then the portfolio will suffer losses.
A prudent risk management is required such as squaring of the stocks on hitting stop loss and keeping profit cap at individual stock level. Apart from this, the portfolio must be reconstructed with fresh stocks at regular intervals and portfolio must hold a large number of stocks. This will help to limit concentration to a stock.
As per latest industry trends, more hedge fund are biased towards the long side to capitalize on rising equity markets. More details about this trend can be found in the article on Bloomberg: Long-Short Hedge Funds Are Ditching the Shorts to Focus on Longs.
Historical performance of the long-short strategies of a hedge fund can be found at EurekaHedge. The Eurekahedge Long Short Equities Hedge Fund Index is an equally weighted index of 1102 constituent hedge funds. The index shows a return of 7.55% in 2017 YTD (as at Aug 2017) and returns of 3.75% in 2016.
Hedge fund charge roughly 2% as annual management fees and 20% of profit as performance fees. These fees are on the higher side compared to mutual funds and ETFs which have around 1% to 3% as the expense ratio.
In summary, a long-short strategy may help to generate less volatile returns in different market conditions but also involves some risk such as correctly predicting the performance of the stocks in the portfolio.
If you want to learn various aspects of Algorithmic trading then check out the Executive Programme in Algorithmic Trading (EPAT™). The course covers training modules like Statistics & Econometrics, Financial Computing & Technology, and Algorithmic & Quantitative Trading. EPAT™ equips you with the required skill sets to be a successful trader. Enroll now!