CPD: Long/short investing

Investors and advisers alike are well accustomed to ‘long-only’ investing, while short selling is often perceived negatively. However, long/short equity strategies can often deliver better returns and lower volatility for investors.

A long/short equity strategy is an investment approach that aims to achieve equity like returns with less volatility than the equity market. It does this by taking both long and short positions in specific companies.

At a basic level, a long/short equity strategy seeks to profit from share price appreciation from its long positions and price declines in its short positions. Such strategies aim to provide investors with returns that beat their respective benchmark, whatever the prevailing market conditions – an important differentiator from long only funds during periods of market volatility.

When managing a long/short strategy, the investment manager can add value in two ways:

• from rising share prices in the long positions held in companies they believe will rise in price
• from falling share prices in the short positions held in companies they expect to experience price falls.

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. Such a portfolio can be better positioned to ride out market volatility.

How does a long/short equity strategy work?

A long only manager focuses on selecting those stocks most likely to prosper in the future and deliver positive returns for investors. The long/short equity manager has a larger investment universe to select from because they can look beyond the good news stories and take advantage of negative views of companies and sectors, as well as weaker market and stock specific fundamentals.

When managing a long/short equity strategy, the manager aims to benefit from the upside of those companies with a positive outlook and sound growth prospects by taking a long position. The goal is to capture an increase in value through this position. In a long/short equity fund, managers buy the stock outright, just as in a traditional long-only equity fund.

When the long/short manager believes a company will experience a decline in its share price, they may establish a short position.

In simple terms, the manager borrows the stock, generally from a broker, sells the borrowed shares to another buyer and collects the proceeds. Once the share price of the stock has declined to a specific price target, the manager can then purchase the shares in the open market at a lower price than those they sold. They are then returned to the broker who loaned the original shares.

Shorting a stock is profitable if the stock price falls between the time it is borrowed and the time it is returned. This combination of long and short positions provides the long/short manager with a large degree of flexibility and enables more active decision making around company’s prospects.

What is an active extension strategy?

Some long/short equity strategies are also known as ‘active extension strategies’. This is a strategy whereby the investment manager shorts some stocks and then reinvests the proceeds in additional long positions to achieve a net stock exposure of 100%.

Active-extension funds are usually represented by a ratio such as 130/30 or 150/50.

For example, an active-extension 150/50 fund is generally 150 percent invested in long positions and 50 percent invested in short positions.

How can the long portfolio be greater than 100 percent?

Figure one illustrates the workings of a 150/50 long/short equity strategy; in this scenario, the manager can short up to 50 percent of its market value and reinvest the proceeds; this provides the strategy a greater exposure to the market than a long only strategy.

To put this in monetary terms, if you have $100 invested in an equity portfolio in an active-extension 150/50 fund, there would be $50 allocated to short positions. This generates $50 through short selling, which is then invested into long positions.

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. This amplifies the opportunities for the long/short equity manager to generate returns.

Just like a long-only equity fund, an active-extension fund has 100% net exposure to the market and will rise and fall with equities.

Why invest in a long/short equity strategy?

There are several reasons to include a long/short equity strategy in your clients’ portfolios.

Enhanced return potential

Skilled investment managers seek to generate alpha, the excess return above the market benchmark. Long/short equity managers have the potential to do this by exploiting two sources of investment return. 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.

Long/short equity 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.

Long/short equity fund managers are also less constrained than some of their long-only peers.

Mitigate volatile markets

Long/short funds aim to generate positive returns regardless of the market direction. While traditional long-only equity funds generally depend on rising markets for profits, long/short funds have the flexibility to make money in both rising and falling markets.

During periods of market volatility, such as those experienced over the past two years, long only strategies will typically follow the respective equity market. This may result in investors losing capital, particularly in the event 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. A strategy that minimises losses can better position investors to weather market drawdowns.

Long/short funds can mitigate volatility because they have the flexibility to adjust market exposure. During bullish phases, the investment manager can increase long exposure, while during bearish phases, they can increase short exposure or move to cash.

While 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, 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.

A diversified approach

Diversification is the cornerstone of every investment portfolio; however the Australian market tends to be skewed, creating a challenging environment for managers due to concentration and crowded trades.

The Australian share market is small by global standards, representing approximately two percent of world markets. Our market is also concentrated. Unlike other developed markets, Australia is dominated by a small number of large companies – the top 10 stocks comprise approximately 48%^[1] of the market capitalisation of the S&P/ASX200 Index. In turn, the top 10 is 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.

Long/short equity funds can provide a way to diversify a portfolio. By holding both long and short positions, investors can potentially reduce the impact of market volatility on their overall returns.

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. Shorting creates opportunities for diversification without high concentration risk.

Risk and return

All investments carry some degree of risk; long/short equity funds are generally considered to be a higher risk option because they carry a greater number of active stock positions. However, the ability to short and hedge can allow for better risk control.

Long/short equity strategies are generally style-neutral – unlike many long-only funds – and therefore not reliant on market timing. As such, a long/short equity strategy aims to deliver positive performance in any market cycle or through any style shift.

The main risk associated with long/short investing is that it amplifies the investor’s exposure to the manager’s investment skill. If the stock selection is poor, then the outcome will generally 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.

In conclusion, a long/short equity fund can be a valuable addition to investor portfolios due to its unique ability to navigate various market conditions. By combining long and short positions, these funds offer a dynamic approach to managing risk, provide diversification benefits and potentially generate positive returns in both bull and bear markets.

While a long/short equity fund is often considered to be a more appropriate strategy for those who are younger and in the accumulation phase of their investment life, there’s an opportunity to broaden the investor audience.

Older investors, even those moving to the retirement phase, could consider a long/short strategy for some of their retirement savings. Longevity risk is a real concern for some of these investors and one of the potential risks is that retirees will run out of money before they run out of life. Investors are increasingly realising that opting for a completely conservative investment allocation may not be a viable solution. They recognise that there may need to be some allocation towards growth assets, and a long-short Australian equity fund may meet that criteria.

The equity market rarely prices a stock accurately and long/short equity strategies offer an investment approach that takes advantage of this…and in today’s market environment, the mispricing opportunities are many and varied on both the long and short side of the equation.

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Notes:
[1] Source: S&P Dow Jones Indices, ASX-200 Fact Sheet, 29 February 2024

The information included in this article is provided for informational purposes and is general advice only. It does not take into account an investor’s own objectives, financial situation or needs. The information contained in this article reflects, as of the date of publication, the current opinion of GSFM Pty Ltd and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. GSFM Pty Ltd, its related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. © GSFM Pty Ltd 2024