The Long/Short Approach
A rationale for equity substitution
Robin Lowe, CAIA, Head of Equity Hedged (US & Europe)
Patric Gysin, CFA, Head of Equity Hedged (Asia & Emerging Markets)
Glossary of terms
Alpha: the component of investment return that can be attributed to the skill of the fund manager(s).
Beta: the component of investment return provided by (positive or negative) market movements (alpha +/- beta = total return).
Drawdown: a term used to describe the extent of a decline in asset value from peak to trough in any given cycle. In the context of equity
long/short strategies, drawdowns typically occur during bear markets and the extent of the drawdown of the fund is often compared to the
percentage fall in the market.
Leverage: a term used to describe the degree to which an investor utilises borrowed money or speculative derivative positions to enhance
investment returns. In the context of an equity long/short approach, fund managers typically use some or all of the proceeds of selling
stock short to ‘lever up’ their long exposure, but it is very unusual for excessive borrowed capital to be deployed.
Liquidity: a relative term describing the speed at which an asset or assets can be converted into cash (liquidated) and vice versa.
MSCI World: a widely used composite index of capital-weighted stocks developed by Morgan Stanley Capital International, which acts as
a proxy for world stocks when assessing the relative performance of any portfolio with global asset exposure.
Prime broker: in the context of a long/short equity approach, a prime broker acts as the intermediary between the two counterparties
involved in short selling, by matching a stock borrower (equity long/short manager) with a stock lender (typically a pension fund or large
institution). The prime broker also collects margin payments from short sellers should the market price of the stock move against them.
Short selling: a trading technique whereby an investor (long/short manager) makes an agreement with a ‘prime broker’ to borrow stock
from a stock lender. The stock is then sold by the long/short manager with a view to buying it back at a lower price in the future.
Stock lender: any party holding a long position in a stock can earn a lending fee by providing a prime broker with the opportunity to find
an equity long/short manager that wishes to ‘short’ the same stock. Lenders are typically large institutional investors who wish to ‘own’ the
stock over the long term
Despite delivering lacklustre returns for over a decade, stocks continue to play a hugely
significant role in the performance of many investment portfolios. Small private investors
and large institutions alike allocate to equities simply because they have investment
objectives which cannot be met or liabilities that cannot be funded through the rates of
return currently available from other traditional asset classes. In today’s uncertain
environment, the three attributes investors should target are liquidity, transparency and
asymmetric returns. Traditional long-only equity funds provide two of the three but the
pronounced inconsistency in year-on-year investment returns presents severe
difficulties to those making strategic asset allocation decisions.
Equity long/short managers are able to generate investment returns with extremely
attractive dynamics – a high participation in the upside potential of stock markets
combined with a much lower correlation to equities during bear phases
The primary return driver for equity long/short strategies is alpha while market beta
will largely dictate whether a long-only discipline produces positive returns
A well constructed portfolio of alpha-generating equity long/short managers should
produce superior risk-adjusted returns to any long-only discipline
The rise and fall of passive investment
In response to scathing criticism about its inability to justify active management fees
with value-added investment performance during the 1970s, the traditional asset
management industry set about developing synthetic methods of replicating index
performance (the first index fund was established by Wells Fargo in 1973).
Consequently, by the late 1990s, it had never been easier or cheaper to acquire stock
market beta by virtue of the extraordinary range of tracker funds which had become
widely available. At the same time, academic research shows that the average equity
risk premium was wider between 1982 and 1999 than during any other comparable
period in history. Diversification was therefore a concept to avoid rather than embrace
and investment profits were largely generated as a function of stock market risk.
The 1990s was a decade in which beta triumphed over alpha, but the early years of the
new century have been characterised by efforts to segregate these two components of
investment performance. This development recognises that beta is easy to replicate but
Traditional long-only constitutes an unreliable source of return, while alpha is expensive to acquire and
should be rewarded appropriately. The issue for traditional equity disciplines in this
managers levy a fee for respect is that a fee for active management is levied, yet much more beta than alpha is
active management, but
deliver more beta than alpha The Barclays Capital ‘Equity Gilt Study’, refers to the overvaluation of stock markets at
the end of the 1990s as being ‘the most extreme of the past century and indeed of
recorded stock market history’. In the period since then, many investors have
discovered to their own cost (i.e. through experiencing drawdowns of up to 50%) that
cheap beta is far from the ultimate investment solution.
1. Source: ‘Triumph of the Optimists’ Dimson, Marsh and Staunton (2002).
In recent months, we have seen equity risk premiums trend strongly positive once
more and some of the traditional arguments in favour of equities remain compelling.
However, it seems increasingly likely that investors will need to diversify beyond the
traditional investment strategies in order to generate the excess risk premiums that they
benefited from during the final stages of the 20th century. A much greater focus on the
management of downside risk is also a critical issue.
The case for equity substitution
The rationale behind a long/short strategy is to achieve consistent investment returns
through a low correlation to falling stock markets – as demonstrated in the chart below.
A low correlation to falling stock markets (in USD)
1 January 1990 to 31 December 2009
16000 HFRI Equity Hedge (Total) Index USD 14,256
12000 MSCI World Index hedged to USD (price return)
Index value USD (log scale)
2000 USD 1,834
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
‘Winning by not losing’ –
avoiding large drawdowns Equity long/short managers have the ability to bring more advanced investment
techniques into mainstream asset management in an intuitive and transparent manner.
will significantly enhance It is certainly the case that the long/short approach provides a number of benefits which
should help investors to meet strict objectives regardless of the trading environment.
average returns Moreover, it can either be deployed as a stand-alone strategy or as an additional
component of a broader equity allocation.
Large losses undermine long-term returns and should be avoided where possible.
The Wall Street Journal refers to this as ‘the cruel math of big losses’ – when a large
drawdown is incurred, a much bigger gain is required in order to restore parity. This
problem can be exacerbated by negative compounding which occurs during extended
bear phases. Consequently, the investment return earned can, in practice, be
significantly lower than that implied by the arithmetic return.
Distribution of real annual equity returns over 109 years
Frequency of monthly return
Source: Adapted from the Barclays Capital ‘Equity Gilt Study’ 2009.
At first glance, the above chart would not give a long-only equity investor any major
cause for concern because the largest positive return exceeds the largest negative
return. For example assuming the worst case scenario of an investment returning -50%
in the first year and the best scenario of +60% in year two, the arithmetic return is
+10%. However, the investment return is actually negative as a rebound of 100% is
required to counteract a drawdown of 50%. The actual value of the investment would
therefore have declined by 20%, rather than appreciating by 10% as the arithmetic
return would imply.
Consequently, the fundamental justification for the long/short equity approach is that
A ‘short book’ is essential to the very existence of a ‘short book’ is essential to ensure a degree of downside
protection in the event of an abrupt market reversal. The downside insulation exhibited
ensure a degree of by equity long/short strategies is the key to their greater consistency, and the attractive
performance dynamic it creates is often referred to as an asymmetric return profile.
downside protection in an
abrupt market reversal 1
Worst six quarters for global equity markets (in USD)
-20 % Man Long Short Equity Global USD I
MSCI World Index hedged to USD (price return)
Dec 08 Sep 02 Sep 01 Jun 02 Mar 08 Sep 08
1. Source: Man database and Bloomberg. Period of analysis: 1 August 1999 to 31 December 2009. There is no guarantee of trading performance and past performance is not a
reliable indicator of current or future performance.
In technical terms, the return distribution of long-only equity investment can be described
as ‘negatively skewed’ or having ‘fat tails’. That is to say the probability of extreme market
events (2000, 2008 etc) is high, and the mean return is typically lower than the median
return drawn from the same data sample. The negative skew is unavoidable because
long-only managers control their tracking error relative to a benchmark index and are
The event risk associated therefore subject to market event risk.
Conversely, long/short managers are focused on constructing portfolios based on
with long-only investment
high-conviction security selection and total, rather than benchmark-relative, risk. As the
primary return driver is manager skill rather than stock market beta, the event risk
can largely be eliminated associated with long-only investment can largely be eliminated. In a portfolio context, it is
possible for a long/short equity manager to aim to substantially participate in the upside
of equity markets, earn positive returns in sideways markets and preserve capital in
By virtue of the lower level of volatility inherent in the long/short approach, these
disciplines also generate superior risk-adjusted returns in comparison to traditional
long-only indices, as illustrated in the chart below. In addition, the different return
dynamics make equity long/short an ideal diversifier for long-only exposure and an
allocation to (e.g.) Man Equity Hedged Strategies can significantly enhance the overall
efficiency of any equity portfolio.
Superior risk-adjusted returns (in USD)
4% Man Long Short Equity Global USD I
S&P 500 TR
W orld stocks MSCI Europe Index (USD)
-2 % FTSE All Share Price Index
6% 8% 10 % 12 % 14 % 16 % 18 % 20 % 22 %
1. Source: Man database and Bloomberg. Period of analysis: 1 August 1999 to 30 November 2009. There is no guarantee of trading performance and past performance is not a
reliable indicator of current or future performance.
An overview of equity long/short
The ‘long’ aspect of any equity long/short strategy adheres to the conventional
Equity long/short managers investment methodology of buying ‘attractive’ shares to benefit from an anticipated rise
in their price. An additional short portfolio serves as a hedge against market declines
are able to achieve a high but also provides an opportunity for managers to generate another source of alpha by
selecting stocks more likely to underperform the broader market. Academic research1
upside participation with a shows that far fewer resources are applied to researching overvalued stocks compared
to undervalued ones, implying that greater alpha potential can be generated from short
much lower correlation to selling. Having two separate sources of alpha therefore not only allows long/short
managers to create additional value for their investors, but also places significantly less
emphasis on beta in determining the success of the strategy. Consequently, equity
long/short managers are able to generate investment returns with extremely attractive
dynamics – a high participation in the upside potential of stock markets combined with
a much lower correlation to equities during bear phases.
The concept of short selling
In 2008, the practice of short selling attracted much adverse comment as politicians
and other public figureheads sought to apportion the blame for sharp falls in share
prices across the financial sector globally. As the credit crisis heightened, in spite of a
blanket ban in the short selling of financial stocks, it became widely recognised that
‘shorting’ was a natural reaction to toxic balance sheets rather than a fundamental
cause of the market stress.
In his Nobel Laureate address in 1990, William F Sharpe, one of the originators of the
Capital Asset Pricing Model, referred to the ‘societal’ advantages of shorting. He stated
that its exclusion would result in “a diminution in the efficiency with which risk can be
allocated in an economy’” potentially leading to lower overall welfare.
The problems associated with a one-sided market are effectively exacerbated by the
use of leverage (borrowing money to buy stock), while shorting (borrowing stock to sell)
is the obvious counterbalance. In addition, shorting increases the depth of the market,
thereby reducing the spread, or transaction cost, incurred by market participants.
Numerous pieces of academic research confirm that market quality (i.e. greater liquidity
with less volatility) is enhanced by short selling activity. Indeed, in commenting on the
impact of short selling restrictions in December 2008, Professor Charles Jones, Chair of
the Finance and Economics Division at Columbia University, stated “virtually every piece
of empirical evidence in every article ever published in finance concludes that without
short sellers, prices are wrong”.
The ability to sell short therefore also promotes efficient price discovery because it
allows markets to incorporate grounds for pessimism in share prices. This results in
more accurate pricing of securities and helps to prevent misallocation of capital in
1. Source: ‘Profit from both winners and losers’ Jacobs and Levy.
Portfolio construction and metrics
In addition to the traditional and intuitive role of security selection, there are three factors
which will determine the relative success of any long/short strategy:
1. effective management of gross/net exposures
3. long/short ratio
The gross market exposure is the sum of the absolute value of the long and the short
positions and illustrates the extent to which (if at all) leverage is applied, while the net
market exposure is equivalent to long market exposure less short market exposure.
The equity long/short approach allows the systematic (or market) risk to be actively
The equity long/short controlled through the management of gross and net exposures. In reviewing past
exposures, research shows that hedge fund managers gradually increased both net
approach allows for and gross exposures from the first quarter of 2003 until the second quarter of 2007 in
order to capitalise on the increasing opportunities they were able to identify and to
systematic risk to be benefit from a lower level of overall market volatility. Having peaked at the end of the
second quarter, levels began to decline in advance of the sub-prime affliction as
actively controlled managers re-evaluated their exposures in light of escalating risk.
However, it is important to consider that most equity long/short managers are not
primarily focused on trying to determine market direction, but rather amend their
exposures as a by-product of prudent management. Unlike their long-only
counterparts, long/short managers invest only where they see attractive risk-adjusted
opportunities and are able to exclude certain positions when market conditions are
Active management of gross/net exposures
60 % 2.0
Jan 07 May 07 Sep 07 Jan 08 May 08 Sep 08 Jan 09 May 09
The above chart examines how the underlying managers in a fund-of-funds portfolio
(Man Equity Hedged Strategies) were able to adjust their exposures from the peak of
the 2003-07 bull market through the credit crisis and beyond and create value for their
Source: Man database.
investors. This clearly demonstrates that the ability of long/short managers to dial-up or
dial-down their exposures, in accordance with active portfolio construction and sound
risk management, can provide proportionate participation on the upside and greater
insulation on the downside.
The data in the table below can be used to help illustrate the potential influences of
leverage and the long/short ratio.
2. Long-short equity 3. Long-short equity
Exposure 1. Long-only equity
Capture index returns
Objective Generate consistent returns Generate consistent returns
+ some alpha
Alpha generation Long -only positions Long + short positions Long + short positions
Long 100 % 130 % 70 % ( balance in cash)
(Short) (0 %) (80 %) (30 %)
Gross exposure 100 % 210 % 100 %
Net exposure 100 % 50 % 40 %
Long/short ratio n/a
N/A 1.6 2.3
The term leverage (or ‘levered’) can be applied to any fund with gross market exposures
of more than 100%. This is the case for some of the more active equity strategies
pursued in the traditional asset management arena, such as 130/30 funds, which use
the proceeds of short selling stocks to the value of 30% of total assets to
proportionately increase their long exposure and potential returns.
Another measure of relative exposures is referred to as the long/short ratio, which is
expressed as the long exposure divided by the short exposure. The significance of the
The judicious application long/short ratio is that it will help to determine the balance between downside and
of moderate leverage
Using the statistical data in the table shown above, assuming that the stock market falls
can enhance returns by 15% and each manager adds the same proportionate value through stock selection ,
the following scenarios would play out:
fund 1 would achieve an investment return of -10%
fund 2 would return +3%
fund 3 would return -1%
Consequently, despite appearing more leveraged and directionally focused than fund 3,
fund 2 would achieve the best results in this scenario. Consequently, the conclusions
that can be drawn from this example are twofold; the judicious application of moderate
leverage can enhance portfolio returns, while the long/short ratio, in conjunction with
gross/net exposures, constitute important aspects for investors to consider.
1. Value added stock selection assumptions: long positions return -10%, short positions return -20%, market returns -15%.
Equity long/short managers also offer attractive liquidity terms in comparison to most
Equity long/short provides other enhanced-alpha strategies, although complexities in the execution of these
disciplines make it difficult to meet investor expectations of daily subscriptions/
attractive liquidity terms redemptions. In particular, the short sale of borrowed securities involves depositing
collateral with a prime broker, while daily marking-to-market can result in margin calls.
compared to most other As such, the administrative burden makes it both difficult and potentially costly to
reverse a number of short positions simultaneously. A spate of unexpected
enhanced-alpha strategies redemptions could be met by simply liquidating long positions but this would unsettle
the balance of gross and net exposures. Similarly, holding a cash reserve to ensure
daily liquidity would dilute investment performance. Consequently, equity long/short
seeks to balance the needs of investors by providing favourable liquidity terms without
compromising investment returns.
Implementing equity substitution
In general, and over time, the majority of equity long/short managers tend to carry a
slight net-long bias within their portfolios. However, there are many different approaches
within the long/short spectrum.
Key dynamics of active long/short equity strategies
Market Market Investment
Style Geographic Industry focus Time horizon
exposure capitalisation approach
▲ Net long ▲ Value ▲ Small ▲ Global ▲ Fundamental ▲ Sector specialist ▲ Short term
▲ Market ▲ Growth ▲ Mid ▲ Regional ▲ Macro ▲ Generalist ▲ Medium term
▲ Momentum ▲ Large ▲ Country ▲ Thematic ▲ Long term
▲ Net short specific
▲ Agnostic ▲ Technical
▲ Short selling
Source: Adapted from AIMA Canada’s strategy paper: ‘Long/Short Equity’ by Colin Stewart, CFA, and Keith Tomlinson, CFA.
As can be seen from the table above, the breadth of the universe creates an ideal
critical mass from which fund of hedge fund managers can seek to blend disciplines
with complementary characteristics in order to optimise risk-adjusted returns.
As part of the research process, fund of hedge fund managers look for a competitive
edge (i.e. some unique skill, such as superior analytics or opportunistic trading which is
evident in the execution of the discipline and can be repeated in the future) when
selecting disciplines for inclusion in their portfolios.
Where investors decide to make direct investments in the long/short arena, it is
important to bear in mind that diversification is key. The presence of ‘outliers’ in the
return distributions found in the equity long/short arena means that injudicious manager
selection should be avoided. Consequently, it is essential that investors look for proven
short-selling expertise, a credible performance track record and sound risk
management before committing assets.
The equity long/short approach gives investors access to two separate sources of
alpha and flexible beta, which can collectively create attractive, asymmetric returns.
The impact of alpha is frequently magnified in long/short disciplines as compared to
long-only portfolios, as it normally stems from both the long and short side of the
portfolio. In addition, as equity long/short is much less concerned with index weightings
and other portfolio constraints, manager conviction and skill can play a significantly
greater role. Relative to other hedge fund strategies which offer attractive risk-adjusted
returns, the equity long/short approach is also liquid and transparent.
The ability of equity long/short strategies to protect capital in prolonged bear markets
Experienced fund of hedge makes market timing much less of an issue for investors determining strategic asset
allocation decisions. The Pyramis Pulse European Pension Insights Survey, published
fund managers can add in December 2009, highlighted a common issue for trustees; exposure to various asset
classes has become misaligned with strategic targets because of exceptional volatility
value through rigorous and returns. Some respondents stated that they were substantially underweight
equities. This reflects a failure to increase equity exposure to compensate for the slump
manager selection in the value of their equity portfolios in 2008 and early 2009. As a consequence, the
strength of the subsequent rebound has exaggerated the misalignment of asset
weightings. Conversely, a similar proportion of respondents highlighted their need to
manage equity exposure lower in order to rebalance risk budgets. Both of these groups
could benefit from the implementation of an equity substitution strategy.
There are singular risks associated with equity long/short investing. Consequently,
experienced fund of hedge fund managers can add significant value through rigorous
manager selection, as well as easing the administrative burden on behalf of their
investors. The risk of fund attrition is also mitigated in a portfolio context.
In summary, the main attributes of equity long/short disciplines are as follows:
they can generate a superior, asymmetric return profile in comparison to
they can insulate investors from the implications of large drawdowns; and
relative to most other enhanced-alpha strategies, they are liquid, transparent
A well-constructed portfolio of alpha-generating equity long/short managers should
continue to produce enhanced risk-adjusted returns in comparison to any relevant
equity index or long-only disciplines over a normal market cycle. Such portfolios
constitute a compelling form of equity substitution and can add significant value in
enhancing the efficiency of a broader equity allocation.
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