What is Long-Short Investing?

expand icon99risesexpand iconexpand icon26 OCT 2021
Long-short investing
TABLE OF CONTENTS

What is Going Long?

What is Shorting?

Enhanced Return Potential

Long-Short Portfolio Construction

Downside Reduction

Greater Diversification

Impact Investing

Picking the Right Longs and Shorts

Real World Example

Why Equity Long-Short?

References

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An equity long-short strategy is one that involves taking long positions in stocks that are expected to increase in value and short positions in stocks that are expected to decrease in value.

What is Going Long?

Going long is simply buying a stock in the open market. You would do that if you think the intrinsic value of the stock is higher than its trading value.

What is Shorting?

Shorting, or short-selling, is when an investor borrows shares and sells them, hoping he or she can buy them up later at a lower price, return them to the lender and pocket the difference.

Some traders do short selling purely for speculation, however, 99Rises does it to hedge, or protect, the customer’s downside risk if they have a long position owned against the short, or if we think the intrinsic value of the stock is less than what it is trading at.

Please see Figure 1 as reference for the discussion that follows. Suppose you believe the stock price of ABC is grossly overvalued, and the stock's going to crash sometime soon. You believe this so strongly that you decide to borrow 10 shares of ABC stock from your broker, and sell the shares with the hope that you can later repurchase them at a lower price, return them to the broker, and pocket the difference.

Fig.1

Short-selling

You proceed to sell the 10 borrowed shares at $10 each, pocketing $100 in cash. In reality, you would pay a small commission, and, depending upon timing, might also have to pay dividends to the buyer of your shares, but these are omitted in the example for simplicity.

So you now have $100 in cash and have an obligation, at some point in the future, to purchase and return the 10 shares of ABC stock. If the stock goes up above the $10 price, you'll lose money because you'll have to pay a higher price to repurchase the shares and return them to the broker's account.

In the example above, the stock ABC goes down in value to $9 per share (say due to missed earnings estimates). You then purchase the 10 shares at $9 per share for $90 and deposit them back to the broker, thus pocketing $10 in the process.

Enhanced Return Potential

Combining long and short positions may provide the potential for excess returns by participating in the upside when markets rise while also helping to guard against market volatility as markets fall.

Fundamentally, our process sticks to buying undervalued stocks and shorting overvalued stocks. Therefore, over time, we will make returns on the spread between the stock price movements of the two stocks.

For example, if you own 10 shares of stock ABC for $10 each and short 10 shares of stock XYZ for $10 each, on day one, you will have a long exposure of $100 as well as a short exposure of $100 i.e. your market exposure which is adding long and short exposures (or “delta”) is zero.

Let’s say stock ABC increases in value to $11 a share and stock XYZ decreases in values to $9 a share. Your long position is now worth $110 and your short position is worth $90. If you liquidate both these positions at these prices, you will pocket the difference between the long and short positions or $110 - $90 = $20. This is your profit for this particular pair.

Long-Short Portfolio Construction

As explained in the “Enhanced Return Potential” section, we have laid out how to create a pair trade between stock ABC and stock XYZ.

Extend that logic to a total of 20-30 pairs which really then becomes your long short portfolio. What is different is that your total long value is sum of all your long positions while the short value is the sum of all your short positions. Now, the portfolio delta or market exposure is calculated by subtracting the total short exposure from the long exposure.

At this juncture, your portfolio can either have a positive, negative or zero delta. This means that your portfolio is either net long the market, net short the market or market neutral.

The return objective function as an aggregate, then becomes either:
1) all the longs go up more than the shorts,
2) all the short go down more than the longs, or
3) the longs go up and the shorts go down.

Any of the above conditions is a necessary but sufficient condition for your portfolio to make positive returns.

Downside Reduction

Lower net market exposures aim to limit downside participation while still providing upside participation. By understanding how each stock in the portfolio moves with respect to the market, or the beta of the stock, we can appropriately size each position so that violent market moves cause an almost equal move in your long and your short, thereby minimizing downside.

We are then purely betting on the individual merits of that company’s asset base, a fundamental bet.

Greater Diversification

A portfolio of long and short positions may provide greater flexibility than traditional investments by finding multiple sources of risk and return.

For example, if you like the upside potential of a cleantech stock ABC and think there is a downside to a cigarette company stock XYZ, you could buy ABC and short XYZ as a pair. You are obviously betting on making the spread between the stocks, but are also diversifying your industry exposures.

Impact Investing

Another very powerful means of expressing a view like that is really expressing your values in the stock market. Your investments should reflect who you are and a long-short strategy like this helps you drive change in management team behaviors and have a positive social impact around you!

So vote with your pocket!

For example, there is a cost associated for issues today that are not quantified fully. For example, global warming. If these costs are added on to some companies business models, they will screen overvalued and therefore will be shorts as investments.

A long-short model helps you drive positive impact and social change faster! Stock performance incentivizes change in C-suite behavior!

Picking the Right Longs and Shorts

It all starts with picking the right pair. Due diligence, management meetings, fundamental data analysis, company valuation modeling and position sizing are critical in driving returns for a pair, and as an extension, your portfolio.

You will need to understand the business of each stock and make sure that your longs are overvalued and shorts are undervalued. If your analysis goes awry, it is possible that your shorts will outperform your longs and you will make negative returns. So leave the stock picking to our algorithms and investment professionals.

Real World Example

In 2008, when the market crashed by almost 50%, long-short strategies flourished all the while when retail investors in ETFs and vanilla long stocks got annihilated. For example, one of the esteemed funds we know was long Goldman Sachs (GS) and short Lehman Brothers (LEH).

Although both were exposed to subprime mortgages, LEH was exposed more than GS. So while GS dropped 35%+, LEH went bankrupt and lost 100%. The fund made a cool 65% spread on this long-short pair trade all while successfully being able to navigate volatility.

Why Equity Long-Short?

Let’s look at a hypothetical example. Let’s say a hedge fund takes a $1 million long position in Pfizer and a $1 million short position in Wyeth, both large pharmaceutical companies. With these positions, any event that causes all pharmaceutical stocks to fall will lead to a loss on the Pfizer position and a profit on the Wyeth position. Similarly, an event that causes both stocks to rise will have little effect, since the positions balance each other out.

So, the market risk is minimal.

Why, then, would a portfolio manager take such a position? Because he or she thinks Pfizer will perform better than Wyeth.

Equity long-short strategies such as the one described, which hold equal dollar amounts of long and short positions, are called market neutral strategies (referenced in the “Long-Short Portfolio Construction” Section). But not all equity long-short strategies are market neutral. Some fund managers will maintain a long bias, as is the case with so-called “130/30” strategies. With these strategies, hedge funds have 130% exposure to long positions and 30% exposure to short positions. Other structures are also used, such as 120% long and 20% short. (Few hedge funds have a long-term short bias, since the equity markets tend to move up over time).

Equity long-short strategies can also be distinguished by the geographic market in which they invest, the sector in which they invest (financial, healthcare or technology, for example) or their investment style (value or quantitative, for example). Buying and selling two related stocks - for example, two stocks in the same region or industry - is called a “paired trade” model as mentioned in prior sections. It may limit risk to a specific subset of the market instead of the market in general.

Thus, in a long-short strategy, when markets go up, your net long bias keeps your returns if pairs are selected correctly, but when the market crashes, your short hedges your risks.

Final Observations

Equity long-short strategies have been used by sophisticated investors, such as institutions, for years. They became increasingly popular among individual investors as traditional strategies struggled in the most recent bear market, highlighting the need for investors to consider expanding their portfolios into innovative financial solutions.

We conclude that long short strategies can present valuable innovations to the toolbox of portfolio choices. While past performance is not a guarantee for future gains, we posit that in specific types of market conditions, especially bear markets, the performance of long short strategies is known to beat the market, hedge your downside and protect your assets.

References

1. Bloomberg
2. MAN Institute

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