Long short hedge fund strategy: A beginners guide

Long-short equity investing is a hedge fund strategy that involves taking long positions in stocks that are expected to increase in value and short positions in stocks that are expected to decline. This time-tested approach balances bullish and bearish bets to generate returns while hedging against market risk. 

For newcomers to alternative investing, long-short equity offers an accessible entry point to grasp the basic mechanics of a hedge fund. 

This introductory guide will cover:

– A brief history of long-short equity

– How the strategy works 

– Instruments and techniques used

– Risk management benefits

– Performance drivers and fund examples 

– Resources for further learning

By the end, you’ll have a solid understanding of this foundational hedge fund strategy.

The origins of long-short equity trace back to Alfred Winslow Jones in the late 1940s. Jones, a sociologist turned financial journalist, created the first “hedged fund” by combining long positions in undervalued stocks with short positions in overvalued stocks. 

This market-neutral approach helped cushion losses during downturns. By running a balanced book of longs and shorts, one side could profit while the other loses. Jones also incorporated leverage to enhance returns.\

Over the decades, long-short equity strategies evolved with advanced fundamental and quantitative techniques. However, the core concept of balancing bullish and bearish trades persists in modern incarnations.

Long-short has cemented itself as one of the most popular hedge fund strategies, with esteemed practitioners like Joel Greenblatt and Jim Chanos demonstrating its potential.

A long-short hedge fund strategy invests in undervalued stocks expected to rise while also shorting overvalued stocks expected to fall. This balanced approach goes long and short simultaneously to focus on relative valuation and stock-picking skill while muting exposure to general market moves. The dual mandate is to identify stocks likely to appreciate as well as those likely to decline.

Long-only equity refers to a traditional investment strategy of simply buying stocks with the expectation they will increase in price over time. The portfolio contains exclusively long positions without any short positions.

Rather than hedging market risk through shorting, a long-only equity strategy is bullish and benefits from stocks and the overall market trending upwards.

While less complex than long-short approaches, long-only equity lacks the advantage of bearish bets balancing the risk of longs.

The dual mandate of long-short equity is to identify both undervalued stocks likely to rise and overvalued stocks poised to fall. Fund managers conduct research to determine which specific stocks fit into each bucket.

Longs: The long book consists of stocks expected to appreciate based on fundamentals pointing to the upside. These are bought with the goal of profiting from their price increase.

Shorts: The short portfolio contains stocks deemed overvalued and likely to decline in price. Short positions are taken by borrowing the shares, selling them, and then repurchasing at lower prices in the future to return them. The fund pockets the difference.

Ideally, the longs and shorts balance each other with market neutrality. If the S&P 500 drops 

5%, the short book gains offset the losses on the longs. This hedging effect helps mitigate against broad market moves.

At the individual stock level, gains on winning long positions are amplified by losses on offsetting shorts. As undervalued longs rise and overvalued shorts fall, the price divergence compounds returns beyond just picking winners.

Equities

Since long-short trades both long and short stock positions, the strategy focuses heavily on equity research. Long short equity funds scout out attractively priced shares across market caps, sectors, and geographies.

Positions can range from safe value plays to speculative growth stories on both sides. The long portfolio favors stocks with identifiable catalysts and an upside runway.

Leverage

The use of leverage is common in order to boost returns from the long-short equity spread. Borrowing magnifies gains from individual positions and the overall fund.

Typical leverage ratios range from 2-3x, meaning a $100 investment controls $200-$300 in equity positions. This gives larger exposure to the upside from winners.

Derivatives

Beyond straight equity trades, derivatives like options, swaps, and futures are often incorporated to enhance exposures.

For example, a long-short fund could purchase put options as a hedge against market declines. Or short equity index futures to quickly gain short exposure rather than shorting individual stocks.

Risk Management 

The ultimate appeal of long-short equity is reducing exposure to general market moves. Directional risk is muted when longs and shorts offset each other.

This allows funds to focus on individual stock-picking skills and the excess returns captured from relative value trades.

Short positions act as a hedge, with gains balancing out long positions during declines. The portfolio doesn’t depend solely on bull markets to drive returns.

In addition, risk management techniques like portfolio diversification, position limits, and stop losses help contain the downside from any single name.

While long-short funds come in many variations, the common drivers of performance include:

Stock selection skill – Identifying overvalued shorts and undervalued longs to maximize the upside spread between them. Winners should outpace losers.

Market volatility – Price swings allow timing entries and exits to repeatedly capture value disparities. Low volatility markets challenge long-short trading.

Leverage – Borrowing magnifies the gains of individual positions and the overall portfolio when successful. But it can also exacerbate losses.

Risk controls – Maintaining balance between longs and shorts avoids unhedged exposure. Stop losses and diversification help contain stock-specific risks.

Trading costs – Excessive transaction fees dug into profits from repetitively rotating positions can be a drag on net returns.

While countless funds employ long-short equity approaches, a few names stand out for their success and longevity, named in this long-short equity hedge funds list:

– Renaissance Technologies Medallion fund has put up unparalleled returns of over 66% annualized before fees since 1988 using short-term quantitative strategies.

– Pershing Square Capital Management, run by Bill Ackman, has generated nearly 20% annualized returns over 18 years with high-profile activist long positions. 

– Greenlight Capital, managed by David Einhorn, has returned over 19% annually since 1996, primarily using long-short equity with a concentrated portfolio.

– Palomar Capital has a 20+ year track record of 20%+ returns from fundamental stock picking combined with macro hedges.

One of the largest and most successful long-short equity hedge funds is Renaissance Technologies’ Medallion fund, which pioneered quantitative trading strategies and has put up unparalleled returns over 30+ years.

Medallion currently manages over $15 billion in assets using short-term statistical arbitrage models and high frequency trading. The fund’s closed-end structure and long investor lockups provide trading advantages and stabilize its volatile approach.

Medallion has generated annualized returns of over 66% before fees since 1988, cementing its status as one of the largest and most renowned long-short equity funds.

For readers interested in further exploring long-short investing, two classics of financial literature provide a wealth of insights:

– Reminiscences of a Stock Operator by Edwin Lefèvre – This fictionalized biography of  trader Jesse Livermore imparts timeless wisdom on speculation and markets.

– The Intelligent Investor by Benjamin Graham – Considered by many the definitive text on value investing, outlining Graham’s philosophy which remains relevant today.

Long-short equity investing has earned a central place in hedge fund strategies over 70+ years by leveraging both bullish and bearish equity bets. The balanced approach produces returns not dependent solely on rising markets.

While no strategy is a cure-all, the concept intuitively makes sense. By going long attractively priced stocks and shorting overvalued ones, funds focus on relative valuation discrepancies. The longs and shorts balance market risk.

Now that you understand the background, objectives, and dynamics of this versatile strategy, you can dig deeper into long-short equity with a grasp of the investing wisdom it offers.

How much do long-short equity hedge funds charge in fees?

The typical fee structure is a 1-2% annual management fee plus 20% of any returns over a set benchmark. So, fees are higher than traditional funds, but you pay for specialized skills.

Is leverage used a lot with this strategy?

Leverage ratios of 2-3x are common with long-short equity. This means a $100 investment controls $200-$300 in equity positions. Higher leverage can get risky quickly.

What does a basic long-short equity portfolio look like?

Portfolio allocation is usually balanced, with 40-60% in long stock positions and 40-60% in short positions. This neutralizes overall market exposure.

What liquidity issues can crop up with long-short equity?

Short squeezes can happen if short positions must be exited quickly in thinly traded small caps. Long positions in microcaps also face liquidity constraints.

How big does a firm need to be to run these strategies?

You need some major assets under management. Most long-short equity funds manage hundreds of millions at a minimum to fund operations.

What is a long-short equity strategy?

A long-short equity strategy invests in undervalued stocks expected to rise while also shorting overvalued stocks expected to fall.

What is the difference between long and short equity?  

Long equity buys stocks outright seeking appreciation, while short equity borrows then sells stocks now to repurchase later at lower prices.

Is a long-short equity fund a hedge fund?

Yes, long-short equity is a common hedge fund strategy. It may also be a mutual fund.

What are the advantages of a long-short equity trade?

A long-short trade balances market risk and focuses on stock-picking skill by going long and short simultaneously.

What is the largest long-short fund?

One of the largest long-short equity funds is Renaissance Technologies’ Medallion fund, which manages over $15 billion.

Why work in long-short equity?

Long-short equity provides opportunities to use leverage and derivatives to maximize returns from equity research and relative value trades.