We are influenced by our experiential bias, what we learn first or have done often. Coming from a trading background going short feels as natural to do as putting the car in reverse. It's just part of the process of getting to the destination. Only slightly different than putting your car in drive, and likewise usually for shorter periods of time. Yet, there seems to be an aura of mystery surrounding what a long short strategy is? Some people have vaguely heard the term and usually in the context of hedge funds. So here's a brief synopsis.
A long short strategy is a type of investing or trading that uses both long positions and short positions.
A long position is when an asset is bought at a certain price in the hope that the price will increase and be sold for a profit at some time in the future, and is the most prevalent type of activity used by retail investors.
A short position is where an asset is sold in the hope that the price will decrease and be bought for a profit at some time in the future, and is an advanced activity used mostly by professional investors.
To execute the original sell order of a short position the asset is supposed to be borrowed from a long position holder. Subsequently, when the buy order of the short position is executed the asset is returned to the long position holder.
While there are many variations of long short strategies, there are two significant sub-strategies, market neutral and leveraged, that reflect different viewpoints of the market(s) they are participating in, how to profit, and risk.
A market neutral strategy is a sub-strategy of a long short strategy that attempts to hold equal levels of capital employed in long and short positions. The objective is capital preservation while gaining returns above the risk free rate, to dampen or strip away perceived market risk, and reduce portfolio volatility.
A levered or leveraged long short strategy uses more than 100% of the capital available. Typically the leverage is gained by using the cash proceeds from the sells on the short positions (short sales) to finance purchases of long positions. For example a portfolio is 100% invested in long positions, it sells 30% of the value of the portfolio in short positions, and uses that 30% to purchase 30% more in the long positions. This leaves the portfolio at 130% long and 30% short. The objective is capital appreciation with greater than target benchmark returns while having volatility similar or higher than then benchmark. Market exposure, as the strategy name implies, is greater than 100%.
A paired trade is when a long position and a short position are put on in an asset category in order to dampen the market risk of the portfolio related to an idea. The category could be a specific industry, or region, or concept. For example, let's say you want exposure to the oil and gas industry. Maybe you think Conoco is better positioned and will outperform Exxon, so you buy Conoco, going long, and sell Exxon, going short. Both will be impacted by geopolitical and economic concerns, and of course the price of crude oil. The paired trade dampens the risk of only going long Conoco, as long as it outperforms Exxon.
UPSIDE DOWNSIDE CAPTURE
A key factor in the success of any investment strategy is upside vs. downside capture. Upside capture is how much of an uptrend in the underlying market do you actually receive and downside capture, like it sounds, is how much of a downtrend or pullback in the underlying market do you actually receive. Clearly you want to have more gains and less losses. The way long short strategies outperform is not by beating other strategies in huge gains but rather to limit losses in broader market declines. Depending on the type of long short strategy, the volatility may be lower, equal, or greater than the broader market, yet they all generally seek to limit losses. The limiting of losses as a risk management tool can provide a method for long term success in an investment strategy.
- The ability to analyze and execute ideas by the manager is a key success factor in long short strategies.
- The strategy fees are normally higher than passive investment vehicles.
- The risks should be actively managed.
- Depending on the type of strategy, such as leveraged, you could be taking on greater than market risk.
- May underperform in strong market rallies.
- In challenging market environments long short strategies have a history of outperforming passive strategies by significant margins, reducing market exposure.
- Ability to profit from declines in the market.
- Dampening of risk is possible.
- Expanded opportunity by being able to profit from both up and down movements in markets, indices, regions, sectors, and individual situations.