As Founder, CIO and CEO of Jabre Capital Partners, Philippe Jabre heads a leading Swiss independent wealth management firm and multi-family office. This article will look at long-short equity strategies, and how they can offer investors an effective hedge against market volatility and other risks.
As the name suggests, long-short equity strategies centre around investing in publicly traded equities and equity-related instruments in both the short and long-term. Compared to long-only investments, long-short strategies have lower sensitivity to market movements as measured by beta, drawdowns and volatility.
When integrated into a broadly diversified portfolio, long-short strategies have the potential to:
- Generate profits from long and short positions.
- Provide an element of risk mitigation when markets decline since gains on short positions will offset losses on long positions.
Short selling is essentially borrowing shares and selling them at a certain price. It centres around the assumption that the share price will decline, enabling the seller to buy shares back at a lower price, then return them to the owner. For short selling to be profitable, the share price must decline. Investors are vulnerable to incurring steep losses should the share price rise instead.
In addition to the benefit of risk mitigation, long-short strategies are typically a flexible investment approach, enabling investors to adjust their risk profile in line with changing market conditions. They are not tethered to a benchmark, nor are they required to maintain static exposures. Managers adopting a market-neutral stance can adopt various steps to reduce risk and protect capital, for example:
- Reducing position sizes to reduce volatility.
- Incorporating portfolio protection in the form of futures, options or index hedges.
- Reducing overall portfolio gross exposure by simultaneously selling longs and covering shorts so the portfolio has less capital at risk.
With equity strategies accounting for more than 40% of all active hedge funds today, there is huge variety in individual investment styles. Funds might focus on particular geographies or industries, each targeting a different gross and net exposure, holding period, number of positions per portfolio, and more. While an investor with 100 positions and holding periods spanning weeks to months will largely be viewed as a trader, one with just a dozen positions and multi-year holding periods will typically be regarded as a long-term investor.
Single-manager funds using long-short equity conduct careful due diligence, doing deep dives into the company fundamentals of each investment option by reading through earnings calls, filings, and other material, potentially even doing-on-the ground research. On the other hand, multi-manager hedge funds investing in long-short equity focus less on detailed research and more on getting the quarters right so their fund can profit after earnings are announced.
Most long-short equity investment strategies follow the same fundamental steps to ensure that a stock is valued appropriately, building a valuation based on multiples, the discounted cashflow, or another intrinsic value-based methodology.
Historically, long-short strategies have held their own in market downturns. During the bear markets of 2000 to 2002, 2007 to 2008, and 2022; along with the down markets of 2011, 2018 and 2020, long-short equity strategies broadly achieved their goal of mitigating risk relative to broad markets across a variety of metrics, according to the HFRI Equity Hedge (Total) Index.
In these unprecedented times, investors are increasingly seeking out innovative ways of increasing the resilience of their portfolio. Nevertheless, past performance is no indicator of future performance. Short-long equity investors will always face four key risks, namely:
- General market movements.
- Company-specific factors unrelated to the wider market.
- The risk of an investment sold short generating significant losses due to appreciation of the share price.
- The risk of loss due to an improperly hedged portfolio and/or unexpected interaction between longs and shorts.
