Long/Short Equity Hedge Funds - Strategy Outline

In principle, it all sounds easy enough. You've had a number of years in the business of traditional "long only" fund management. You've honed your ability to pick winners from the crowded, noisy universe of stocks, and you're feeling constrained by your inability to short the losers, and also by that ubiquitous foil to performance - the Index. So you decide to take that brave leap from the "relative" to the "absolute" space. This is a place where freedom and creativity reign supreme. Congratulations, you've just left the frying pan. Hopefully you aren't entering the blast furnace.

The purpose of a long / short equity hedge fund is to provide absolute returns by investing in stocks with superior return characteristics, and by disinvesting in or "shorting" stocks with inferior return profiles. Typically, these funds will also show some bias to the long or short side - based either on the strength of the manager's conviction in his positions, or on a market view.

The challenge in running such a portfolio is in balancing the return profiles. Put simply, there are three potential outcomes. The most favourable outcome is when long positions rise in value and short positions decline - known as "double alpha." Another outcome is when one side of the portfolio - either the long or the short book - moves favourably and to a value in excess of the other book. This is called "single alpha." The third potential outcome is when both sides of the portfolio move against the manager - the shorts increase in value, and the longs decline. We refer to this in hushed tones as "double splat." Obviously the manager attempts to generate double alpha wherever possible, but at the least he will strive to secure single alpha, with the opposing position constituting a hedge.

The manager has a number of ways in which to deploy capital. One method is known as a "pair" or "relative value" trade. In this case, a manager will select two stocks, for thematic or quantitative reasons, that currently or historically display a strong correlation. Should the stocks deviate from this relationship, a manager can open long and short positions, seeking to profit as they revert. The key is ensuring that in fact there is a demonstrable reason for the pairing.

Another approach is to open short and long positions that are not necessarily connected by a theme, but in such a way that the overall portfolio's sectoral exposure and beta value are appropriately matched. Depending on the manager's appetite (and mandate) for risk, this may result in an intentional overweighting or "bias" toward the long or short book.

Finally, a manager may choose to take an unhedged position, based upon his conviction. Such "naked" positions require stringent risk management procedures, but can be highly rewarding to the portfolio.

Running a short book can feel unnatural and disquieting for many beginners. The spectre of unlimited losses can undermine even the most robust arguments if the market moves against the manager. Managers may be emotionally motivated to ride their losses into oblivion, or to close the positions too soon, generating cost for the portfolio without receiving the benefit of the research into the company. In order to mitigate this risk, it is highly advisable to put in place firm limits to gross and net exposures for the overall portfolio, and to limit the size or value of each position within the portfolio. Adhering to these limits without question will reduce the volatility of the portfolio over time. Please always recall that that your portfolio is someone else's investment. No one wants excessive volatility in investments, unless they happen to own an antacid business!

Another important consideration in running a long/short strategy is the scalability of your strategy. Those managers who have enjoyed success in their funds are occasionally seduced by the prospect of increasing their capital base by taking new subscriptions. However, market liquidity (particularly in the short book) may dictate that the fund can reach a size at which it is difficult or impossible to exploit certain investment opportunities. At best, growing too large may impede optimal performance. At worst, it could lead to "style drift" (when a manager departs from his stated investment style) - which will undoubtedly upset the end investor.

Leverage is an often misinterpreted word, with negative connotations attached. Using leverage will, in some investors' minds, conjure images of "cowboys" taking outsized bets, looking for that "killer" return. To my mind, leverage is not necessarily an evil. Rather, it is a tool that, under controlled circumstances, may be employed to increase overall exposure to a portfolio stocked (if you'll excuse the pun) with good ideas. Investors can be persuaded of the benefits of getting "more bang for their buck" if the intent to leverage is fully disclosed and subsequently managed in compliance with the stated objectives and the return target of the portfolio.

Finally, the long/short model implies that the manager must be somewhat opportunistic in his approach to investing. Properly-timed entry and exit of positions, and by extension understanding the market's movement, can become a significant contributor to alpha generation. However, the manager must be careful not to let his attention wander from the strategy to the screen. A balance must be struck between attention and distraction.

Long/short investing is particularly effective in large, liquid markets, with good trading access and where corporate disclosure is perhaps not optimal. This allows the fundamentally driven long/short manager to derive advantage through a thorough investigation of the company or companies in question. The momentum or trading-driven long/short manager will also be advantaged, profiting from volatility.

Managing all the aspects of the long/short model is challenging, and the investor knows this. The investor accepts risk, but needs to feel that the manager is comfortable in his ability to identify and mitigate the risks inherent to this strategy. Thus, a manager can greatly assuage any investor concerns by offering a clear articulation of how he intends to balance each of the aforementioned elements. In turn, the ability to offer this explanation entails a thorough consideration of all the relevant issues.