Long / short equity
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Long/short equity is an investment strategy, generally associated with hedge funds, which involves buying certain stocks long and selling others short. There usually isn't a restriction on the country that the stocks trade in either. [1]
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[edit] Overview
A fund manager typically attempts to ensure that all of his positions are covered, particularly in regards to market sectors. A hedge fund that wishes to guard against market volatility will typically utilize this strategy.
It is typically done as follows
- A manager examines his positions within a single industry. This is important, since the entire point is to guard against developments that might damage an industry as a whole.
- The manager picks two stocks that are indexed to the market in general. Good examples would be Intel for semiconductors, Nokia for cellular phones, or Johnson & Johnson for the consumer goods market. These are stocks he wishes to purchase for the fund anyway.
- The manager takes two diametric positions within that industry, one being a long position and the other being a short position. He attempts to buy such an amount as to equalize their relative value to each other.
- The manager then is hedged against market-wide disruptions of his investment.
[edit] Examples
For example, a long/short fund manager might sell short one automobile industry stock, while buying (taking a long position) on another -- short of DaimlerChrysler, long on Ford. Thereafter, any general development that improves the yield of auto industry stocks in general will help this fund's Ford position, but will hurt its DaimlerChrysler position. Likewise, any general development that worsens the yield of auto industry stocks in general will hurt the Ford position, but will help its DaimlerChrysler position. The two positions are offsetting, so the portfolio is hedged against developments that affect the auto industry in general. Now, the manager can proceed with whatever he wanted to do with those stocks in the first place.
[edit] Differences from Market Neutral Strategies
This isn't the same as a true equity market neutral strategy, which may be regarded as just the limiting case of long/short. The key point, though, is that a long/short manager is taking a position on the relative value of the two companies. He is making a bet to the effect that, wherever the industry as a whole is going, company A will do better than will company B. A market-netural strategy attempts to simply balance losses against gains.
[edit] Problems with Long/Short Equity
There are significant difficulties in achieving this sort of equity, which is why only institutional traders and hedge funds engage in them. Primarily, there is the cost of setting the trades up, of balancing the portfolio, and picking the index stocks. There are also additional costs in the 'two for one' arrangement of L/S E, since basically a manager is gambling the market is unstable. If the market remains very stable, small fluctuations may ruin him -- his long position may sink and his short position may rise, leaving him with nothing. [2]
