Equity Strategies: Long/Short Equity

Long/Short Equity

Long/short (L/S) equity managers engage in the purchase of equities they anticipate will appreciate (long positions in undervalued companies) and the short selling of equities they believe will decline in value (short positions in overvalued companies). The primary objective of long/short equity strategies is to remain adaptable in identifying appealing opportunities on both the long and short sides of the market and to allocate them effectively within a portfolio. Long/short equity strategies can shift between industry sectors, factors, and geographic regions depending on their specific mandates. Nevertheless, in practice, most managers retain their core philosophies and areas of focus, typically emphasizing fundamental research.

While some managers may attempt market timing using “beta tilts,” research indicates that many fundamental long/short equity managers do not consistently add alpha through such adjustments. They often find themselves either excessively bullish during market peaks or insufficiently bullish during market troughs. Most L/S equity managers are not particularly renowned for their market-timing abilities, but those with such skills can bring additional value to portfolio allocation decisions.

L/S equity managers can also hold concentrated positions in high-conviction buy or sell decisions and can apply leverage to amplify these positions, particularly among quantitatively oriented managers. Consequently, stock selection predominantly defines the skill of most L/S equity managers, with market-timing ability considered an optional, albeit secondary, factor. Long/short equity strategies represent one of the most widespread hedge fund approaches, accounting for approximately 30% of all hedge funds.

Investment Characteristics

Manager skill in long/short equity primarily stems from their ability to select stocks. As a result, individual long/short equity managers often specialize in specific geographic regions, sectors, or investment styles. These managers are characterized by their strategy focus, capacity to maintain long and short positions over time, and use of leverage.

Long/short equity managers' exposures to various equity factors can significantly differ depending on their specific mandates. For example, a manager specializing in small-cap growth stocks may have a positive exposure to the size factor and a harmful exposure to the value factor. In contrast, a manager concentrating on large-cap value stocks could have a harmful exposure to the size factor and a positive exposure to the value factor.

Since equity markets generally experience upward trends, most long/short equity managers usually maintain net long equity positions. Some managers keep short positions as a safeguard against unexpected market downturns. In contrast, others adopt a more opportunistic approach by increasing short positions in response to negative findings regarding a company's management, strategies, or financial statements or when their valuation models signal to sell opportunities in particular stocks or sectors. Therefore, a manager's performance during market crises is critical in differentiating among hedge fund managers.

Given the typically high fees associated with hedge funds, avoiding paying these fees for beta exposure that can be obtained more cost-effectively through traditional long-only strategies is essential. The primary objective in long/short equity investing is to seek unique sources of alpha, primarily through stock selection and, to a lesser extent, market timing, rather than relying on embedded systematic beta.

Risk profile and liquidity

1. Long/short equity strategies benefit from a diverse global opportunity landscape, allowing them to generate alpha through careful stock selection.
2. These strategies encompass various investment styles, including value/growth, large cap/small cap, discretionary/quantitative, and industry specialization.
3. Long/short equity managers typically maintain average exposures ranging from 40% to 60% net long, comprised of gross exposures between 70% and 90% in long positions and 20% to 50% in short positions, although these levels vary widely.
4. The return profiles of these strategies are designed to achieve annual returns similar to those of a long-only approach but with a 50% lower standard deviation, reducing portfolio volatility.
5. Some managers employ index-based short hedges to mitigate market risk, while most seek single-name short positions to enhance portfolio alpha and achieve additional absolute returns.
6. A few managers can add alpha through market timing of portfolio beta tilts, although the evidence suggests that most long/short managers struggle with this aspect.
7. Long/short equity strategies suit limited partner and mutual fund-type vehicles.
8. These strategies are characterized by liquidity, diversity, and mark-to-market pricing driven by publicly available market quotes. Including short positions reduces beta risk and offers an additional potential source of alpha, contributing to reduced portfolio volatility.

Leverage Usage

The degree of leverage employed in a strategy often increases as it adopts a more market-neutral or quantitative approach, aiming to attain a significant return profile.

Benchmark

Long/short (L/S) equity benchmarks include the HFRX and HFRI Equity Hedge Indices, Lipper TASS L/S Equity Hedge, Morningstar/CISDM Equity L/S Index, and Credit Suisse L/S Equity Index.

Strategy implementation

When combining long and short stock positions within a portfolio, the market exposure is determined by the net of the beta-adjusted long and short exposures. Long/short equity managers often maintain modest net long exposures, averaging between 40% and 60% net long, although brief periods of being net short can occur, particularly with a strong short position.

Many long/short equity managers naturally gravitate toward specific sectors, structuring their funds around their industry expertise. These specialist managers thoroughly analyze fundamental situations from a top-down and bottom-up perspective. Typical areas of specialization encompass complex sectors like telecom/media/technology (TMT), financial, consumer, health care, and biotechnology. In contrast, generalist long/short managers adopt a broader approach, allowing them to invest across various industry groups. However, they may avoid more intricate sectors, such as biotechnology, due to the binary nature of outcomes tied to drug trials. While generalists offer flexibility, they may overlook industry-specific nuances that have become increasingly important in a news-intensive and nuanced world.

In essence, long/short equity investing typically involves extracting alpha from long and short positions through single-name stock selection, often combined with inherent net long exposure in the form of embedded beta.

Equity Approaches: Dedicated Short Selling and Short-biased

Dedicated short-selling hedge fund managers exclusively take short positions in equities they perceive as overpriced relative to their deteriorating fundamentals. They might adjust their short exposures primarily regarding portfolio size, occasionally holding higher cash levels. Short-biased hedge fund managers adopt a less extreme approach, actively seeking opportunities to short overvalued equities while potentially balancing their short exposure with modest value-oriented or index-oriented long positions. This approach helps short-biased hedge funds navigate extended bull markets in equities.

Short sellers actively seek to generate returns that move in the opposite direction of the overall market. They do this by identifying issues like failing business models, fraudulent accounting practices, corporate mismanagement, or any other factors that can negatively affect how the market sees a particular stock.

However, making money through short selling has become more challenging in recent years. This is because global stock markets have been on a long-term upward trend, making it difficult to bet against them successfully. As a result, there are fewer successful short sellers today compared to the 1990s.

One notable exception is the emergence of activist short selling, where managers take a short position in a security and publicly present research supporting their short thesis. Suppose the hedge fund manager has a strong reputation from past activist short-selling endeavors. In that case, the release of this research can trigger a significant stock price decline, allowing the activist short seller to cover a portion of their short position. In the United States, this practice is not considered market manipulation by securities regulators, provided the activist short seller does not disseminate false information, does not charge for such information, and acts in the best interests of their limited partner investors.

Investment Characteristics

Short-selling managers focus on identifying overvalued equities of companies facing deteriorating fundamentals that the market has yet to recognize. They aim to maximize returns during market declines, providing a unique source of negatively correlated returns. Short selling involves borrowing securities, selling them at higher prices, repurchasing them at lower prices, and returning them to the lender. However, this practice involves collateral, interest payments on the loan, and the risk that the lender may demand the securities back at an inconvenient time.

Short selling is challenging due to the inverse relationship between position size and price movement, making risk management complex. It can also hinder access to company management for research. Regulatory restrictions on short selling vary by country, with rules like the “uptick rule” in the United States. Successful short-selling managers often adopt an “attack and retreat” style, with positive returns during market declines and risk-free returns during market upswings.

These managers search for short-selling opportunities among overvalued companies experiencing declining financials, internal conflicts, weak governance, or potential accounting irregularities. Other targets include companies with single, uncertain product developments.

Risk Profile and Liquidity

• Dedicated short sellers solely engage in short-side exposure, possibly offsetting short exposure by holding cash.
• Short-biased managers focus on effective short-side stock selection but may balance short exposure with some value-oriented long positions, index-oriented long positions, or cash.
• Dedicated short sellers typically maintain short positions ranging from 60% to 120% at all times, while short-biased managers are typically around 30% to 60% net short. Both prioritize single equity stock picking over index shorting.
• Return goals for these strategies are generally lower than other hedge fund approaches, but they benefit from a negative correlation. They tend to be more volatile than typical long/short equity hedge funds due to their short beta exposure.
• Managers may possess some capacity to add alpha through market timing of portfolio beta tilt, but this is challenging to do consistently.
• Limited partnerships are typically the most suitable structure for this strategy due to the complex operational aspects of short selling.
• These strategies are attractive for their liquidity, negatively correlated alpha relative to most other strategies, and mark-to-market pricing based on public prices. However, historical returns have been characterized as uneven and generally underwhelming.

Leverage Usage

• Low: Short-selling managers usually rely on the market’s natural volatility and do not require significant additional leverage.

Benchmark

Short-biased indexes comprise the Eurekahedge Equity Short Bias Hedge Fund Index and the Lipper TASS Dedicated Short-Bias Index. Additionally, some investors gauge short-biased funds' performance by contrasting it with the inverse of related stock index returns.

Implementation Strategy

Dedicated short-biased strategies emphasize strategic selling opportunities, making stock selection a pivotal aspect of their investment process. Short-selling managers typically adopt a bottom-up approach, meticulously sifting through a pool of potential sell targets to identify companies whose stock values are likely to decline substantially within the relevant time frame. When identifying candidates for short positions, managers consider various factors, including flawed business models, unsustainable corporate leverage, and signs of inadequate corporate governance or accounting irregularities.

Dedicated short-biased managers employ various tools to identify potential sell candidates, such as monitoring single-name credit default swap spreads, corporate bond yield spreads, and implied volatility of exchange-traded put options. They may also leverage traditional technical analysis and pattern recognition techniques for market timing of short sales. Accounting ratios and measures like the Altman Z-score used to assess a company's bankruptcy risk and the Beneish M-score for detecting potential financial statement irregularities can also be valuable tools.

Due to the inherent complexities and risks associated with short selling, successful sellers often thoroughly analyze their short portfolio candidates. Their meticulous efforts enhance overall pricing efficiency in the market, making them a valuable resource in the investment landscape.

Equity Approaches: Equity Market Neutral

Equity market-neutral (EMN) hedge funds employ strategies that involve taking long and short positions in similar or related equities with divergent valuations. Their primary goal is to maintain a near-zero net exposure to the overall market, thereby neutralizing market risk. EMN managers achieve this by ensuring that the expected portfolio beta is approximately zero and that betas for sectors, industries, and common risk factors like market size, price-to-earnings ratio, and book-to-market ratio are also set to zero.

EMN portfolios often rely on quantitative methodologies and diverse holdings to accomplish this. These portfolios are actively adjusted over shorter time horizons, and leverage is frequently applied to enhance returns. Zero market beta can be attained through derivatives such as stock index futures and options. The overarching objective of EMN portfolios is to capture alpha while minimizing exposure to portfolio beta.

One subset of EMN investing is pairs trading, which identifies similar equities with varying valuations or misalignments in share prices. Positions are established when significant divergences are observed, expecting these differences to revert to their historical mean values eventually.

Another EMN approach is stub trading, which involves buying and selling stock in a parent company and its subsidiaries, weighted by ownership percentages. Multi-class trading focuses on different classes of shares within the same company. When pricing deviates from the norm, overvalued shares are shorted, and undervalued ones are bought to profit from the return to typical pricing relationships.

Fundamental trade setups, such as capital structure arbitrage, may also be used, mainly when long or short equity positions are hedged against bond exposures. These strategies exploit mispricings in anticipation of potential events like mergers or bankruptcies.

Quantitative market-neutral managers often trade many securities and adjust positions frequently using algorithm-based models. This approach, known as statistical arbitrage trading, emphasizes mean reversion and relative momentum characteristics in market behavior. Managers face challenges balancing optimal beta neutrality with the practical impact of frequent portfolio adjustments and associated brokerage costs.

In EMN strategies, the primary source of skill lies in security selection, while market timing is of secondary importance. Sector exposure is limited but may vary depending on the manager's approach. Managers who maintain beta neutrality and specialize in generating alpha through sector rotation exposure are market-neutral tactical asset allocators or macro-oriented market-neutral managers.

Investment Characteristics

Equity market-neutral fund managers aim to shield their portfolios from broader market movements while capitalizing on differences in valuations through specific securities trading. This often involves a quantitative approach that employs substantial leverage to achieve meaningful returns. Nevertheless, discretionary EMN managers typically employ less leverage.

EMN managers are especially valuable for portfolio allocation during periods of flat or declining markets, as they tend to provide more stable and less volatile returns compared to many other hedge strategy areas. Their conservative and controlled approach generally results in less overall volatility in returns compared to managers who embrace market exposure. An exception to this trend is when significant leverage can trigger mandatory downsizing due to excessive portfolio drawdowns. Market-neutral managers employ a strategy known as prime broker portfolio margining, which allows them to take leveraged positions. They can go up to 300% long, meaning they bet on stocks to rise, and 300% short, meaning they bet on stocks to fall. However, there is a crucial risk involved. When their losses reach a certain point, the prime brokers can require them to reduce their portfolio. This risk is particularly significant for quantitative market-neutral managers.

Despite the substantial use of leverage and their more consistent risk-return profiles, equity market-neutral managers are often considered preferable replacements for, or supplements to, fixed-income managers during unattractively low fixed-income returns or a flat yield curve. EMN managers seek a distinct alpha type with its risks, including leverage risk (availability and cost of leverage) and tail risk (performance of leveraged portfolios during market stress).

Risk Profile and Liquidity

• They exhibit relatively modest return profiles, aiming for market neutrality and allowing for different constraints on factors and sector exposures.
• These strategies often feature high levels of diversification and liquidity, resulting in a lower standard deviation of returns than other strategies under normal market conditions.
• Many types of EMN managers exist, predominantly quantitative rather than discretionary managers.
• Time horizons within EMN strategies vary, but they typically focus on mean reversion, involving shorter horizons than other strategies and more active trading.
• Due to the frequent use of high leverage, EMN strategies generally do not comply with regulatory leverage limits for mutual fund vehicles, making limited partnerships the preferred choice.
• EMN strategies are appealing because they capitalize on idiosyncratic short-term mispricing between securities that should otherwise be co-integrated. Their sources of return and alpha do not rely on accepting beta risk, making them especially attractive during market vulnerability and weakness periods.

Leverage Usage

• High: By mitigating various beta risks, such as market and sector risks, EMN managers often find it permissible to employ elevated leverage levels to pursue substantial return objectives.

Benchmark

• Market-neutral indexes encompass the HFRX and HFRI Equity Market Neutral Indices, the Lipper TASS Equity Market Neutral Index, the Morningstar/CISDM Equity Market Neutral Index, and the Credit Suisse Equity Market Neutral Index.

Strategy Impimentation

The construction of equity market-neutral portfolios involves four key steps. The investment universe is initially assessed to include tradable securities with sufficient liquidity and short-selling potential. Next, securities are scrutinized for buying and selling opportunities, utilizing fundamental models (company, industry, and economic data) and/or statistical and momentum-based models. Subsequently, a portfolio is built with constraints to ensure market risk neutrality, striving for a portfolio beta close to zero and often achieving neutrality in a dollar, sector, or other factors. Lastly, leverage availability and cost are factored in, considering the desired return profile and acceptable potential portfolio drawdown risk. The strategy's execution costs regarding rebalancing are also considered as a filter for decision-making on the frequency of portfolio adjustments.

It's important to note that this is a simplified example. In practice, most EMN managers hedge beta at the portfolio level rather than on a stock-by-stock basis. They also consider other security factor attributes.

Question

Which strategy will most likely create synthetic short exposure if out-of-the-money calls are expensive due to positive sentiment?

1. Selling out-of-the-money puts.
2. Selling out-of-the-money calls.
3. Purchasing out-of-the-money puts.

Solutions

The correct answer is A.

This is the strategy that can be employed to create synthetic short exposure. It essentially takes a short position by selling out-of-the-money puts, as they would be obligated to buy the underlying asset if the put options are exercised. This strategy provides a synthetic short exposure to the market.

B is incorrect. Selling out-of-the-money calls is a strategy that generates income but does not create synthetic short exposure. It involves a potentially bullish or neutral stance, as the seller must sell the underlying asset if the call options are exercised.

C is incorrect. Buying out-of-the-money puts is a strategy that provides downside protection or a bearish position but does not create synthetic short exposure. It involves paying a premium for the put options and benefits from price declines in the underlying asset.

Reading 38: Hedge Fund Strategies

LOS 38 (b) Discuss investment characteristics, strategy implementation, and role in a portfolio of equity-related hedge fund strategies.