Long/short equity is among the most fundamental of all hedge fund strategies. Funds using this strategy seek to reduce risk by simultaneously taking long and short positions in various equities. Generally speaking, funds will use short positions in individual securities or equity indices to hedge against any movements in the market and reduce market risk. This isolates the security-specific risk of funds’ long positions and allows funds to benefit from the return potential of individual securities while avoiding broad market-level movements.
Some long/short equity funds have a narrow approach. Some managers focus on capitalization, investing in micro-cap, small-cap, mid-cap, or large-cap stocks. Most long/short equity managers tend to have a long bias, which leads them to have exposure to market risk. Long/short equity managers may also switch their long or short biases based on their expectations of future market conditions.
Long/short managers employ either a bottom-up or top-down investment strategy. A bottom-up strategy calls for managers to select individual equities based on fundamental research about similar equities, as well as events that may have an effect on the future price. A top-down approach calls for managers to use macroeconomic principals to forecast market trends in the global economy, assess their impact on various sectors and geographic regions, and then select individual securities. Typically, long/short equity managers outperform the stock markets under bear market conditions and underperform the stock markets under bull market conditions.
About 65% of all hedge funds are long/short equity, which make it the most popular hedge fund strategy. Recently however, investors have not been as keen on long/short emerging-market funds, which generally have a long bias, as they have been in previous years.
Due to the persistent volatility in the markets in general, and the political and financial instability in Europe specifically, many investors have started to flock to developed market long/short equity funds. These funds promise low correlations to both stocks and bonds, and they have the ability to outperform the market during both bullish and bearish environments. These funds are often interesting to investors seeking the best of both worlds—a safer investment that delivers better returns.