Equity Long Short Strategies

In a long/short equity hedge fund strategy, the fund manager buys (goes long) a portfolio of equity securities and simultaneously sells (goes short) other equity securities in order to partially or completely hedge the portfolio. Alternatively, the manager may use options (long out-of-the-money puts or short covered calls) or equity index futures to implement the short side of the strategy. Many equity long/short managers maintain a long bias by not completely hedging the long exposure through the short position. Aggressive long/short strategies employ leverage to attain greater than 100% net market exposure (i.e., the percent long minus the percent short exposure). For example, an aggressive manager may borrow capital to create a 150% long portfolio (i.e., buying 100% with equity capital and 50% with borrowed debt capital). If he then hedges with a short portfolio equal to 20%, the fund has a net exposure of approximately 130% long. Conservative long/short managers maintain a net market exposure of 100% or less.

Long/short managers do not attempt to predict trends in the broad market but instead rely on stock selection within a geographic region, sector, or investment style. Securities are selected based on top-down and bottom-up analysis. In the top-down analysis, managers assess economic trends in industries or sectors to find attractive opportunities. Stock screening models are then employed to narrow the potential investment universe. In bottom-up analysis, managers analyze individual companies to find securities that are overvalued (candidate for a short position) and undervalued (candidate for a long position). Bottom-up analysis involves an assessment of profitability, cash flow, balance sheet stability, qualitative analysis of management, discounted cash flow analysis, and other techniques. If the manager successfully implements the long/short strategy, the hedge fund's return profile should resemble a call option (i.e., downside protection and upside participation).

Determinants of Return for an Equity Long/Short Strategy

Hedge fund managers tend to attribute the returns on their portfolios to their own stock picking and trading abilities. Undoubtedly, manager skill contributes to the returns on an equity long/short strategy (especially as it relates to small capitalization stocks), but returns are at least partially attributable to risk premia observed in global equity markets. Long/short managers buy undervalued stocks (often small capitalization) and sell overvalued stocks (often large capitalization) during overall rising markets, indicating exposure to risk premia associated with value stocks, small cap stocks, and the broad market. In other . words, long/short managers take on risks related to these areas of the market, just as other investors take on these risks. Therefore a portion of the returns earned by the long/short manager is simply the reward expected for taking on certain systematic risks. However, the delineation between returns attributable to manager skill and returns due to risk premia is not exact. On the short side of the strategy, returns are generated through gains from price declines on shorted stocks, the ability to hedge broad market risk, and the interest earned on the proceeds from short sales (called the "short rebate interest"). In addition, long/short managers are able to exploit inefficiencies in the market created by internal and external short-selling restrictions imposed on other institutional investors.

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