Understanding Long-Short Equity Strategy

For both retail and professional investors alike, most portfolios should strike a balance between risk mitigation and profit-seeking. Long-short equity investing is one strategy that many large-scale investors use to pursue that. In a long-short equity approach, the investor takes a mix of long and short positions, hoping to create a portfolio that is balanced to take advantage of both growth and depreciation in the market.

Defining Long-Short Equity Strategy

Long-short equity strategy is a popular strategy used by many hedge funds where long positions are taken in stocks that have superior return characteristics and short positions are taken in stocks that have relatively weaker characteristics. 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 sometimes also known as a market-neutral strategy.
• It is a mixed portfolio. Most long-short strategies emphasise the long position, often taking a 70/30 mixture of long vs. short positions. This is not necessary, however, and a particularly pessimistic investor could even emphasise short positions if they felt that was wise. 
• Due to the market’s general upward trend in recent years, long-short portfolios that strongly emphasise short positions have been less popular. 
• Many long-short portfolios will emphasise particular markets or geographic areas. 
• For example, an investor could build their portfolio around a specific sector, like technology or automobile firms. This approach will help protect the performance of the portfolio from price falls in any of the sectors and make the portfolio less volatile.

Working of a Long-Short Strategy

The long-short strategy is an investment approach that aims to profit from both rising and falling markets. Despite the absence of guarantees, the overarching goal remains consistent. This strategy involves taking long positions in assets expected to increase in value and short positions in assets expected to decrease in value. It is a versatile and dynamic strategy used by hedge funds and sophisticated investors to generate returns in various market conditions

Long Positions

In a long-short strategy, the long positions are relatively straightforward. Investors buy assets such as stocks, bonds, or other securities with the expectation that their prices will appreciate over time. These long positions can serve as a foundation for the portfolio, providing potential capital growth and income.

Short Positions

The unique aspect of the long-short strategy is the short positions. To go short an investor borrows assets they do not own, typically from a brokerage, and immediately sells them in the open market. The investor then aims to repurchase the same assets at a lower price later and return them to the lender, benefiting from the price difference.

Reasons for Adopting Long-Short Equity Position

There are three main reasons to use this strategy.

Mitigate Systemic Risk

The main reason why large funds take a long-short equity position is to insulate themselves against marketwide exposure. If the market as a whole gains value, as it typically does, a portfolio that emphasises long positions will profit. (Although the investor hopes to have nevertheless correctly identified overvalued stocks.) However, if the stock market declines overall, the portfolio’s short positions will partially insulate it from losses.

Maximise the Spread

The other major goal of a long-short position is to maximise ‘the spread’. This is the difference between the long positions an investor has taken and their short positions. Ideally, investing this way allows an investor to gain on both growth and losses, creating more room for profit than by just investing for market growth alone.

Market Neutral Positions

A less common goal for long-short equity is to build what is called a ‘market neutral position’. In this case, the investor will have invested the same amount of money in short positions as in long ones. The goal of this position is to insulate the portfolio from the market altogether, taking similar losses and gains from overall market trends up or down.

Building a Long-Short Equity Strategy

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

• Step 1: Define the universe
• Step 2: Stock bucketing 
• Step 3: Define parameter to long or short security
• Step 4: Capital allocation

Let’s now learn about each step in more detail and create our own long-short equity strategy.

Step 1: Define the Universe

One needs to identify a universe of stocks in which one can take positions. The universe can be defined based on trade volume, market capitalisation, price, and impact costs. 

Step 2: Stock Bucketing 

From the universe of stocks, one can bucket stocks based on the sector such as technology, pharmaceuticals, automobiles, financial services, and FMCG. 

Step 3: Define Parameter to Long or Short Security

This is the key step in the workflow. 

• One can rank stocks in the bucket based on their past returns performance. Stocks that have performed well will be ranked higher and stocks that performed poorly will be ranked lower.  
• One can use a combination of parameters such as quarterly earnings growth, PE ratio, P/BV, moving averages, and RSI with different weights on each parameter to create a custom profitable strategy suited to one’s trading philosophy. 
• One can go long on stocks with the lower rank and go short on the stocks with the higher rank. 
• Calculate the investment’s compound annual growth rate with Share India’s free CAGR calculator.

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. Alternatively, one can distribute one’s capital based on weighted parameters derived from and suit one’s trading style. 

Choice of Ranking Scheme for Long-Short Equity Strategy

The choice of ranking scheme is the most critical component of this strategy. 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. This decision is for one to make based on one’s preferences. 

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.  

Long-Short Investing and You

• While long-short investing is typically employed by major funds, one can use it to diversify one’s portfolio as well.
• However, a warning: Short positions are extremely risky for the average investor, as they have potentially unlimited losses.
• With relevant stop losses in place, as an individual investor, one could also use a short position hedge against market-wide risk.
• Long-short investing is a diversification strategy involving both long and short positions in the same portfolio, allowing for hedging against systematic risk.
• One should start building the stocks bucket, and create a dedicated market watch on the Share India web app or mobile app.
• In a different investment context, ETF funds provide a diversified and cost-effective way for investors to gain exposure to various asset classes and investment strategies.
• Opening a new trading and DEMAT account online with Share India can be done in a few clicks.

Conclusion

The long-short strategies represent a dynamic and sophisticated approach to investing that has gained popularity among hedge funds and sophisticated investors. This strategy, also known as market-neutral or market-agnostic, distinguishes itself by its ability to generate returns in bullish and bearish market conditions. The essence of the long-short equity strategy lies in its dual approach. On one hand, it entails taking long positions in assets that are expected to appreciate, providing investors with the opportunity for capital growth and income.

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