Hedge funds employ many investing strategies, and the long-short equity strategy is one of them. But what does this long-short equity strategy mean?
Long short equity strategy is a method of investing whereby a trader takes long positions in stocks that are expected to appreciate and, at the same time, takes short positions in stocks that are expected to decline. It is a form of hedging strategy that aims to minimize risk by having both long and short positions while maximizing profits by gaining from the rising values in stocks with long positions and declining values of stocks with short positions.
In this post, we will take a look at the long-short equity strategy and provide you with a specific example. We also make a long short equity backtest at the end of the article.
What is the long-short equity strategy?
The long-short equity strategy is an investment method that aims to achieve positive returns by taking both long and short positions on specific stocks. With this equity strategy, a trader takes long positions in stocks that are expected to appreciate and, at the same time, takes short positions in stocks that are expected to decline.
In principle, it’s the same as a pairs trading strategy.
Of course, going long on a stock shows that one believes that the stock’s price will go up and deliver positive returns. When looking to go long, investors seek opportunities that can deliver either growth, income, or a combination of the two, and they often look for stocks they believe to be undervalued.
On the other hand, investors take a short position when they are convinced that the stock price will go down, and often, they look for undervalued stocks. However, short selling is challenging, at least in the stock market, where you have a tailwind from inflation and productivity gains, which is why short selling is difficult.
Rather than take a long-only or short-only position, the long-short strategy tries to realize returns by buying undervalued stocks that are expected to appreciate and betting against overpriced stocks in expectation of their decline/retracement. So, the strategy improves on the traditional long-only investing by taking advantage of profit opportunities from securities identified as both under-valued and over-valued.
It is a form of hedging strategy that aims to minimize risk by having both long and short positions while maximizing profits by gaining from the rising values in stocks with long positions and declining values of stocks with short positions. While this may not always be the case, the strategy often achieves a net profit. This type of investing method also helps to achieve diversification.
The long-short equity strategy is popular with hedge funds just as the similar but different strategy known market-neutral strategy, in which dollar amounts of both long and short positions are equal.
Due to its nature and relatively complex structure, the long-short equity strategy may not be suitable for retail investors. It is suitable for institutional investors who can use derivatives and leverage to enhance returns and manage risks while employing the strategy. When using this strategy, hedge funds often have a long bias — an example is the 130/30 strategy where long exposure is 130% of AUM and 30% is short exposure.
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Backtested trading strategies
The Medallion Fund, perhaps the best hedge fund of all time, uses long-short strategies a lot (at least the fund used this strategy to begin with).
How does the long-short equity work?
Long-short equity works by exploiting profit opportunities in both potential upside and downside expected price moves. It achieves this by seeking opportunities to take a long position in underpriced stocks while selling short overpriced shares.
So, the first step is to identify stocks that are relatively underpriced and overpriced. The former is likely to rise, while the latter is likely to decline. The investor then buys the undervalued stocks, which already have a margin of safety by trading at a discount, and at the same time, they short the overvalued stocks because they are likely to decline.
Because the stock market generally has an upward bias, many hedge funds also employ a long-short equity strategy with a long bias (such as 130/30, where long exposure is 130% and short exposure is 30%). Only a few hedge funds employ a short bias to their long-short strategy and only if they believe the general market is bearish. It is historically more difficult to uncover profitable short ideas than long ideas.
Apart from the net bias, long-short equity strategies can be classified according to the following ways:
- Market geography — advanced economies, emerging markets, Europe, etc.
- Sector — energy, technology, etc.
- Investment philosophy — value or growth
Long short equity example
To avoid correlation, the long-short strategy is often applied to stocks in different sectors for the long and short legs. For example, if interest rates are rising, as in 2022, a long-short equity fund may go long on a stock in a defensive sector, such as the healthcare sector, and short a stock in an interest-sensitive sector such as the consumer discretionary sector.
After a good research, let’s say the fund identifies that the pharmaceutical giant, Merck & Co., Inc (NYSE: MRK), is underpriced at $85 and that Thor Industries Inc. (NYSE: THO) is overvalued at $75. The fund can go long on MRK with $70,000 and short $30,000 worth of THO stock. That is, the fund buys 823 shares of MRK and shorts 400 shares of THO.
If, as anticipated, MRK rises to $95 per share and THO declines to $65 per share, the fund would make a profit of more than $8,185 from MRK and also make a profit of $4,000 from the short position in THO. So, the fund profits from both the rise in MRK and the decline in THO.
It doesn’t always happen that way. THO could still rise even though the market condition was favoring a decline. Likewise, MRK could still decline, despite the market conditions that favor its rise. Nothing is certain in the financial markets.
Long short funds – examples
A long/short fund can be a mutual fund or a hedge fund. The key thing is that it takes both long and short positions in investments typically from a specific market segment.
Long/short funds often use several alternative investing techniques such as leverage, derivatives, and short positions to increase potential returns. They typically seek to enhance the returns from investing in a specific market segment by actively taking both long and short positions in securities. There are many long-short funds around, and these are a few examples:
- Toews Hedged U.S. Fd: The fund seeks to provide long-term growth of capital while limiting risk during unfavorable market conditions. It invests primarily in equity index futures contracts, as well as U.S. large-cap stocks, ETFs that primarily invest in U.S. large-cap stocks, investment grade fixed income securities, ETFs that primarily invest in investment grade fixed income securities, cash equivalents, and futures contracts on investment-grade fixed-income securities and U.S. treasury securities. It typically employs long-short strategies in its holding and uses technical analysis to find opportunities.
- Boston Partners Global Long/Short Fund: This is a long-short fund that invests in various regions and countries, including the United States (but in no less than three different countries). The fund invests significantly (ordinarily at least 40% – unless market conditions are not deemed favorable by the Adviser, in which case the fund would invest at least 30%) in non-U.S. companies. It principally invests in issuers located in countries with developed securities markets, but may also invest in issuers located in emerging markets.
- Alger Dynamic Opportunities Fund: The fund aims to achieve seeks long-term growth of capital while minimizing risk during unfavorable market conditions. It invests in a portfolio of U.S. and foreign equity securities, including common stocks, preferred stocks, and convertible securities. It uses long-short strategies in its equity investments. The fund may invest a portion of its assets in securities issued by small capitalization companies, as well as in equity securities not listed on an exchange.
- AB Select US Long/Short Portfolio: Under normal circumstances, the fund invests at least 80% of its net assets in equity securities of U.S. companies, short positions in such securities, and cash and U.S. cash equivalents. It focuses on securities of companies with large and medium market capitalizations, but it may also take long and short positions in securities of small-capitalization companies. The fund invests in non-U.S. companies but often limits its investments in such companies to no more than 10% of its net assets.
Best long-short hedge funds
There are many hedge funds around the world, and many of them employ the long-short equity strategy, along with other strategies. Most hedge funds use diversified strategies and do not depend on one strategy alone, so it is difficult to find one that uses only the long-short strategy.
These are some of the best hedge funds that make use of the long-short strategy:
- Bridgewater Associates: One of the most popular hedge funds in the world, Bridgewater Associates was founded by Ray Dalio in 1975. It is based in Westport, Conn., and provides services to pension funds, foreign governments, central banks, university endowments, charitable foundations, and other institutional investors. The fund uses different kinds of strategies, including the long-short equity strategy, and by the first half of 2022, it was up 32%. Ray Dalio and Bridgewater are famous for their All Weather Portfolio.
- Renaissance Technologies: This is a New York-based quantitative hedge fund that uses mathematical and statistical methods to uncover technical indicators that drive its automated trading strategies. Renaissance applies these strategies to U.S. and international equities, debt instruments, futures contracts, forward contracts, and foreign exchange. It was founded in 1982 by mathematician Jim Simons.
- Elliot Management: With a 55-year-long history, Elliot Management is one of the most successful hedge funds. It uses different kinds of strategies, encompassing almost every asset type, such as distressed securities, equities, hedging and arbitrage positions, commodities, real estate-related securities, and so on. It was founded by Paul Singer and is based in New York.
- Davidson Kempner Capital Management: Founded in 1987, the firm is based in New York and has affiliate offices in London, Hong Kong, and Dublin. It uses different types of strategies, including long-short equity, convertible arbitrage, merger arbitrage, distressed investments, event-driven equities, and restructuring situations.
- Man Group: This is a British hedge fund that has been in operation for more than 230 years. It uses a mix of long/short equity funds, private market funds, real estate funds, multi-asset funds, and fixed funds, and its core value is responsible investing, which it achieves through its funds’ compliance with environmental, social, and governance ESG investing goals.
Long short portfolio construction
Constructing a long-short portfolio requires a lot of research and analysis. You want to design the portfolio to grow but limit overall risk. Here is what it can look like with a five-stock example:
- Stock XA: long position, $125,000
- Stock DY: short position, $75,000
- Stock EF: short position, $75,000
- Stock JB: long position, $125,000
- Stock MC: long position, $100,000
In this case, the portfolio is worth $500,000, with a long bias — a 70/30 split between long assets and short. Your expectation is for stocks XA, JB, and MC to go up, while stocks DY and EF to decline. In that kind of scenario, you would make profits from both the long and short positions.
However, if the overall market becomes bullish, and stocks DY and EF also rise, you would still be in profit because your portfolio has a long bias. On the other hand, if the overall market declines, you will lose money due to the portfolio’s long bias, but your investments in stocks DY and EF, which would profit from the decline would mitigate your losses. There are many ways to mitigate risk (and potential losses), and we recommend reading Safe Haven by Mark Spitznagel.
The father of long short strategies: Ed Thorp
Edward Thorp is known as the father of quantitative investing, as he was one of the first who successfully used quantitative models for risk-taking. He is famous for his ability to identify inefficient market areas and figure out ways to take advantage of mispricings.
Before he started his career in the financial markets, Thorp tried his hands at betting and even documented a rational way of betting to beat the casinos in blackjack in his book, Beat The Dealer.
Thorp went on to study the financial markets, and in 1967, he published a book about arbitrage, Beat The Market. He started trading the market and all his trading strategies are 100% quantified and mechanical. Thorp founded Princeton Newport Partners (PNP) in 1969 and ran it till 1988. All through those years, PNP never had a losing year, and its returns compounded at 19.1%, almost more than double that of the S&P 500, with significantly less drawdown.
Following an unpleasant encounter with an employee in 1988, Thorp closed PNP and decided to operate a family office.
Long short equity strategy backtest
Let’s go on to present a specific long short strategy backtest example with strict trading rules and settings. The strategy backtest is perhaps a bit naive, but it serves as a helpful illustration of how you can go about creating a portfolio of long short pairs.
Specifically, we look at two of the most iconic brands on the planet: Coca-Cola (KO) and Pepsi-Cola (PEP). Most of the time these two companies go in tandem, except where there is specific company news that makes them go separate ways.
We backtest the following trading rules:
- We create a pair ratio that is simply the price of KO divided by PEP.
- We create a 5-day RSI of the pair.
- If the RSI value in no. 2 goes below 20, we invest 50% of the equity in KO and short 50% in PEP.
- When the RSI value returns to 60, we cover both our positions done in no 3.
- If the RSI value in no. 2 goes above 80, we spend 50% of the equity short-selling KO and spend the remaining 50% on a long position in PEP.
- We cover our position from no 5 if the RSI value goes below 40.
Here’s the link for a complete description of the RSI indicator. The strategy’s historical performance can be found in this equity chart:
Our simple long short strategy backtest performs pretty well, although it has long periods with flat or negative performance.
Here are a few of the strategy’s performance metrics: The average gain per trade is 0.45%, which is not a lot considering it has four trades in total. The annual return (CAGR) is 3.8% and it’s invested 42% of the time. However, the max drawdown is pretty mild at about 11%
The monthly and annual returns are displayed in the table below:
One important aspect of a long short strategy is to have a portfolio of many pairs, not just one or two. We were trading pairs when we started out with prop trading strategies in early 2000, and we traded a minimum of 10 pairs at all times. You don’t want to be dependent on just one pair. It’s a pretty capital-intensive way of trading.
Code and logic in plain English
Backtesting a long short equity trading strategy requires more coding than just a stock, ETF, or futures contract.
For your convenience, we have made the Amibroker code in this article available to you together with the full list of trading strategies. You get the code together with over 150 other trading ideas. Please click on the green banner below to get an exact overview of what strategies you’ll get:
Because all the strategies have rules in plain English, we believe they are very useful for Python coders and traders (why do traders use Python?).
Long short equity strategy – conclusion
There is a reason why it’s mostly hedge funds and prop traders that trade pairs and long short equity strategies: you need leverage for it to be worthwhile. The average gain per trade is normally low, and thus traders use leverage to ramp up returns, of course at the cost of increasing the risk.
We hope that the long short equity strategy backtest provided in this article can help you get started, or at least make you better understand the strategy.
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