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A long/short equity hedging strategy consists of selecting a core long equity portfolio and then partially or fully offsetting it with short equity positions. The goal is garner returns that resemble those available from a long call option – upside exposure and downside protection. The short equity positions may take the form of short stock positions, short call/long put options, and short futures/forwards, among others.

Most practitioners of long/short equity hedging tend towards a directional long bias – they do not completely hedge their long positions. Of course, in difficult market conditions, this bias may disappear or be reversed. Different styles of investing (such as ones based upon geography, sector, capitalization, book value, etc.) can overlay this strategy. So, for instance, a long/short portfolio may be long “undervalued” stocks or stocks from neglected countries or sectors, and short “overvalued” stocks from popular regions or sectors. Of course, notions of valuation are in the eyes of a fund manager, but there is a general consensus that, for instance, small-cap stocks are systematically undervalued, and hence provide a risk premium (in the case of small-cap stocks, the risk premium is often called a liquidity premium), relative to large-cap stocks. Another example of systematic risk premia involves so-called “value” stocks, as opposed to “growth” stocks. Thus, a typical long/short portfolio may be long small-cap and/or value stocks, and short large-cap/growth stocks (or equivalent short positions in indexes or derivative instruments).

There are many other ways to target undervalued stocks using fundamental analysis in either a top-down or bottom-up approach. Top-down analysis involves identifying socio-economic trends, and then sectors and companies that will benefit therefrom. Bottom-up stock selection rests on the information gleamed from a company’s financial statements, SEC filings, and various external reports (research reports, news articles, personal interviews, trade shows, etc.). In either approach, fund managers may be free to put on positions as they see fit – there need not be any benchmark portfolios associated with a long/short strategy. Thus, managers using this strategy can be unencumbered with the potential drag of trying to outperform a benchmark portfolio.

So, how much does a manager’s superior skill (alpha) contribute to returns from a long/short hedge fund? We have seen that built-in systematic risk premia (beta) can be a significant source of return, as in small-cap or value-based positions. Studies have indicated that up to 70% of returns from this strategy are a result of market exposure. The fact that the strategy works much better in strong up-markets than in flat or bear markets reinforces the perception that much of the return reaped by hedge funds utilizing a long/short strategy arises from beta, and that the added kick provided by alpha may be over-hyped.

A recently-popular variation on the long/short strategy is known as the “enhanced active 100X –X” strategy. A hedge fund manager allocates a percentage of his/her book, say 30%, to short positions, and then, through the use of prime brokerage leverage techniques uniquely available to hedge funds, uses the proceeds from the short sales to put on a long position equaling 100% plus the amount shorted – in this case giving a total long position of 130%. This example would be called an active 130-30 strategy. Quantitative techniques are often used in this variation; as such, it might be termed a hybrid of long/short equity hedging and equity hedged market neutral investing. Before we turn to the latter strategy, we’ll continue next time with an in-depth review of enhanced active 100X-X investing.