The equity market rarely prices a stock accurately and the long/short manager is well positioned to can consistently capture that mispricing.
What is a long/short strategy?
A long/short equity strategy is designed to take advantage of the upside of markets, while minimising potential downside risks. The strategy seeks to profit from share price appreciation in its long positions and price declines in its short positions and aims to provide investors with returns that beat the benchmark, whatever the market conditions.
With this strategy, the investment manager can benefit from rising stock prices by taking a long investment position in selected companies and from falling stock prices by taking a short position in other companies.
Most investors tackle share market investing by taking a long position. However, by adopting an approach that shorts stocks in tandem with a buy and hold approach – a long/short strategy – investors have access to a larger universe through exposure to a portfolio that profits from both positive and negative share price movements and can be better positioned to ride out market volatility.
How does a long/short strategy work?
Freed from the constraint of long only investing, a long/short manager doesn’t just look for the good news stories like traditional equity managers – it can take advantage of negative views of companies and sectors, as well as weaker fundamentals.
The investment manager aims to exploit the upside of companies with a positive outlook and sound growth prospects, and the downside of those with a negative outlook and poor prospects.
The long strategy simply involves buying and holding undervalued stocks that are expected to increase in value over time.
The short strategy is a little more involved. Essentially an investor pays to “borrow” a share from a lender (a broker or a passive index fund) with an agreement to return the stock in the future.
When the short trade is closed, a long stock is sold, and the cash is used to repurchase the stock that was shorted and return it to the lender. As long as the shorted stock has delivered a worse return than the long stock (fallen more or risen less), the trade will be profitable. This process may be conducted many times across a long/short portfolio to generate higher investment returns.
This combination of long and short positions provides an investor with a large degree of flexibility and enables more active decision making.
Short selling has been a controversial topic in Australia and has often been unfairly blamed for creating excessive volatility in markets. However, short selling doesn’t change the underlying fundamentals of a business; in fact, it creates opportunities for investors with differing views, aids in price discovery and provides greater market depth.
Active extension
Some long/short equity strategies are also known as an ‘active extension strategies’ in which the manager shorts some stocks and then reinvests the proceeds in additional long positions to achieve a net stock exposure of 100%.
Figure one illustrates the workings of a 150/50 long/short equity strategy; in this scenario, the manager can short up to 50% of its market value, although the proceeds need to be reinvested so that the Fund maintains full exposure to the market. Other active extension strategies such as 130/30 and 120/20 are also common.
Figure one: Active extension long/short equity strategy
Active extension strategies allow stock pickers to better express their highest conviction stock ideas by increasing underweight and overweight positions relative to the index. They can ‘short’ poor companies with weak financial fundamentals and use those proceeds to increase their ‘long’ positions in the highest quality companies.
Why invest in a long/short strategy?
There are several reasons to include a long/short strategy in your clients’ portfolios.
Additional source of return
Long/short equity managers have the potential to exploit two sources of investment return and act on research and analysis that shows a positive or negative outlook. The manager can add value by short selling a range of stocks with weak investment characteristics and reinvesting the proceeds in long positions in preferred stocks. This combination of long and short positions provides the manager with greater flexibility and enables more active decision making.
Full spectrum of investment insights
Long/short managers can benefit from all of their research and analysis – rather than just avoiding a company because of weak fundamentals, short selling a company’s shares is a way to potentially enhance returns. It can be better to exploit a weakness in a company or sector through an explicit short sold position than simply holding an underweight or zero position.
Attractive risk-return trade off
Long/short strategies aim to provide investors with positive returns, whatever the market conditions. During periods of market volatility, long only strategies such as traditional equity funds and equity ETFs will follow the respective equity markets; this may result in investors losing capital, particularly in the case of a significant market correction or sustained bear market. As illustrated in figure two, once capital is lost, it takes a substantial gain – and time – to recoup those losses.
There is the potential to achieve higher levels of return relative to the benchmark than can be achieved for funds which only take long positions. However, this is partly achieved by taking additional risk. The incremental risk reward trade-off can be more attractive than that offered by long only funds.
Australia’s concentrated market
Diversification is the cornerstone of every investment portfolio, but all too often sharemarket diversification comes by investing only in a selection of stocks drawn from the top 50 or top 100 ASX-listed companies, either directly or through a managed fund.
The Australian share market is small by global standards (representing approximately two percent of world markets) and is dominated by a small number of large companies. In fact, the top 20 stocks comprise approximately 36%[1] of the market capitalisation of the S&P/ASX200 Index, and is, in turn, dominated by financial and mining stocks.
When using a benchmark for constructing an equity portfolio – such as the S&P/ASX200 Accumulation Index – the performance of a traditional fund that takes long only positions will be determined by the size of that fund’s holding of those very large companies relative to that company’s weighting in the index.
In contrast, a long/short fund can also take short positions by borrowing shares from other holders and selling on market, then reinvesting the proceeds in long positions.
By investing in stocks that are expected to rise in value, as well as making money from stocks that are expected to fall in value, an investor is effectively doubling the investment universe available, as well as smoothing out returns and mitigating a traditional long only equity portfolio risk.
Risk and return
All investments carry some degree of risk; long/short funds are generally considered a higher risk as they carry a greater number of active stock positions.
The main risk associated with long/short investing is that it amplifies the investor’s exposure to the manager’s investment skill. If the manager selects stocks poorly, then the outcome will be worse than it would be for a more conservative long only fund.
There is also some additional risk in short selling, and this occurs if the borrowed stock is recalled. In this case, it can also force a repurchase of the share at the same time as the recall. Although this is not a common occurrence, it can happen, and it may mean the share has to be repurchased at a less than favourable price.
This risk can be managed by ensuring that the short positions held are mainly in liquid shares rather than in the smaller, lower liquidity assets whose price moves further in the event of a short squeeze.
Investor suitability
Long-short investment strategies can complement a core holding of long only equities, such as a market index option, by providing the opportunity for alpha at the edges of the investor portfolio.
It is often considered to be an appropriate strategy for those who are younger and firmly in the accumulation phase of their investment life. Recognising that time is on their side, they can take on the added risk that comes with equity exposures and growth assets. A good active manager that can generate returns above the index over time will make a significant different in boosting the superannuation balances of younger investors, and over the long term – with the magic of compounding – show a marked appreciation in the value of their assets.
However, there is also an opportunity for people who are older, even those moving to the retirement phase, to look at long/short fund managers for some of their retirement savings. Longevity risk is a real concern for these investors and one of the greatest risks is that retirees will run out of money before they run out of life.
Increasingly, investors are realising that opting for a completely conservative investment allocation is not a viable solution. They recognise that there should be some allocation towards growth assets, and a long-short Australian equity fund may meet that criteria.
Long/short equity strategies offer an investment style that takes advantage of the precarious nature of the equity market…because the equity market is such an emotional instrument, moving from greed to fear, the mispricing opportunities are many and varied.
The equity market rarely prices a stock accurately – it’s always too much or too little, and the long/short manager is well positioned to can consistently capture that mispricing. It’s a complete instrument in generating an equity return that can capture equity market exuberance.
Glossary:
Long – a long position comprises the purchase of a security with the expectation that the asset will rise in value.
Short – a short position results from the sale of a borrowed security with the expectation that the asset will fall in value.
Short squeeze – occurs when an event changes the prospects of shorted stock for the better; this tends to result in a sharp rise in the stock price, amplified by short sellers covering, or buying back, the stock to close out their position.
Market drawdown – the potential loss or decline of an investment.
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