Of all the investment strategies currently employed by hedge funds, none provides potential for tremendous gain (or loss) more than shorting. To be accurate, a majority of hedge funds use shorts as part of their overall strategy; however, there are three different types of hedge funds where shorts play a major role: 1) short-only hedge funds; 2) short-bias hedge funds; 3) long-short hedge funds. This article will deal with short-only and short-bias hedge funds in order to understand what shorting can add to a hedge fund's arsenal. It should also be noted that with greater innovation in the financial industry, a wider array of financial instruments has opened up new opportunities for short investors. Whereas short investors traditionally had to place positions through buying stock on margin, hedge funds can now place sophisticated shorts against equities and equities indices through derivatives (e.g. options).
There are a number of strategic advantages for equity short hedge funds. The primary advantage for short hedge funds is the opportunity to drive above average returns with contrarian bets. One of the main tenets underpinning shorting is that the market has mispriced a company's value; hedge funds then can short a stock based on the premise that the market price will decline. Many hedge fund managers drove high returns during the market volatility of 2007-2009 based on prescient shorts against market wisdom: David Einhorn of Greenlight Capital shorted a soon to be bankrupt Lehman Brothers; John Paulson shorted a soon to implode housing sector; numerous hedge funds took large short positions against banks with toxic balance sheets such as Bear Stearns, Wachovia and Citibank. These investors posted above average returns due to their foresight to short in the market and the fortitude to stick with their instincts.
Just like many other investment strategies, the weaknesses of shorting are connected to their strengths. While some investors profited handsomely from shorting the market, others posted significant losses, even to the point of liquidation. A main disadvantage of shorting is that investors can face an unlimited downside if the investment sours: Investors who short typically borrow money to buy a stock, sell it, and then gain profit by buying back the shares at a substantial discount to cover the trade. If the stock price increases between the sell and buy date, however, the fund has to cover the difference. Hedge funds that hedge against short positions somewhat limit their exposure; however, that also in many cases limits the upside.
A second main disadvantage is market architecture; that is, the market can make it difficult to scale up and exit short positions. Hedge funds typically make money through assuming concentrated positions that become profitable through ramping up scale - usually through applying leverage (borrowed money). Short positions, however, are notoriously difficult to acquire adequate scale, particularly if other funds adopt a similar position that can lead to a "crowded trade". Finally, there is significant liquidity risk in taking short positions: During the financial crisis, policymakers viewed shorting as a cause of financial volatility rather than a reaction to it. As a result, numerous governments banned short selling on exchanges. Consequently, many investors found themselves unable to get into new, profitable short positions.
In spite of these notable limitations, hedge funds that feature short positions continue to proliferate in the hedge fund space - largely due to significant turnover among short-only funds that have folded. There will continue to be an active market in shorting, particularly among funds that can spot asymmetries in market pricing.
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FAQs
Long-short equity is an investment strategy that seeks to take a long position in underpriced stocks while selling short overpriced shares. Long-short seeks to augment traditional long-only investing by taking advantage of profit opportunities from securities identified as both under-valued and over-valued.
What is equity hedge fund strategy? ›
The most prevalent of the hedge fund strategies, equity strategies hedge funds take long positions in stocks perceived as undervalued and short positions in stocks considered overvalued. Equities' correlation with macroeconomic factors mean they are seen as a riskier class for investment than cash and bonds.
What is the equity hedge strategy? ›
Hedged equity simply involves buying equity in some form, an underlying investment, and then securing a hedge to offset losses connected to market risk (i.e. the whole market sells off or the economy slows due to unpredictable events, like COVID-19 or a mortgage crisis).
What are the key differences between a long-short equity hedge fund and a market neutral equity hedge fund? ›
At first glance, equity market neutral funds can look just like long short funds or relative value funds. The major difference is that equity market neutral attempts to keep the total value of their long and short holdings roughly equal, as that helps to lower the overall risk.
What is the 130 30 long-short strategy? ›
The 130-30 strategy, often called a long/short equity strategy, refers to an investing methodology used by institutional investors. A 130-30 designation implies using a ratio of 130% of starting capital allocated to long positions and accomplishing this by taking in 30% of the starting capital from shorting stocks.
How does a short strategy work? ›
Short selling involves borrowing a security whose price you think is going to fall and then selling it on the open market.
What is the most popular hedge fund strategy? ›
Sub-Categories: The most famous strategy In this category is convertible bond arbitrage, in which the hedge fund will long the bonds and short the company's equity, or vice versa, based on whichever one is underpriced.
Which approach is most commonly used by equity hedge strategies? ›
One of the most commonly used strategies for startup hedge funds is the long/short equity strategy. As the name suggests, the long/short equity strategy involves taking long and short positions in equity and equity derivative securities.
What is an equity long short hedge fund? ›
Long/short funds are designed to maximize the upside of markets, while limiting the downside risk. For example, they may hold undervalued stocks that the fund managers believe will rise in price, while simultaneously shorting overvalued stocks in an attempt to reduce losses.
What is the most effective hedging strategy? ›
Investors use hedging strategies to reduce the downside risk of their investments. Diversification, options strategies, and correlation analysis are some of the most effective strategies for creating a balanced portfolio.
Hedging is the balance that supports any type of investment. A common form of hedging is a derivative or a contract whose value is measured by an underlying asset. Say, for instance, an investor buys stocks of a company hoping that the price for such stocks will rise.
What is an example of an equity strategy? ›
Some prominent examples include value investing, growth investing, dividend investing, momentum trading, and sector rotation. Every equity strategy possesses its own set of unique characteristics, risk profiles, and investment criteria.
What is the EMN strategy? ›
Equity market-neutral (EMN) strategies take advantage of idiosyncratic short-term mispricing between securities. Their sources of return and alpha do not require accepting beta risk, so EMN strategies are especially attractive in periods of market vulnerability/weakness.
What is an example of a market-neutral equity strategy? ›
Example of a Market Neutral Strategy
For example, they may take a 50% long position and 50% short position in any industry in order to remain market neutral. If the market moves up, the losses due to the short positions are offset by the profit made in the long investments.
What is the difference between a hedge fund and an equity fund? ›
Investment Focus: Hedge funds typically invest in publicly traded assets using various strategies to achieve returns, while private equity funds invest in private companies or buyouts with a focus on long-term value creation.
What is a short-term equity strategy? ›
What is short-term trading? Short-term trading involves taking a position that can last from seconds to several days. It is used as an alternative to the more traditional buy-and-hold strategy, in which you'd hold a position for weeks, months or even years.
What is a short equity option? ›
The Bottom Line. The writer of a short option is making a bet that the stock underlying the option will decline in price before the option expires. Win or lose, the writer collects a premium, or fee, for selling the option. But losing this bet can mean unlimited losses for the writer.
What is equity short? ›
Equity is the amount of capital invested or owned by the owner of a company. The equity is evaluated by the difference between liabilities and assets recorded on the balance sheet of a company. The worthiness of equity is based on the present share price or a value regulated by the valuation professionals or investors.
What is the equity strategy? ›
A 100% equities strategy is a strategy commonly adopted by pooled funds, such as a mutual fund, that allocates all investable cash solely to stocks. Only equity securities are considered for investment, whether they be listed stocks, over-the-counter stocks, or private equity shares.
