Short cut to higher returns

Long/short, also known as equity hedge or directional equity, is one of the best known hedge fund strategies. It represents nearly 45 per cent of the hedge fund universe and is the most widely used strategy in the hedge fund world.

While asset flows into the sector were strong in 2001, as markets fell and uncertainty about market direction heightened, many long/short managers focused on capital preservation. In 2001, this resulted in rather lacklustre returns, with long/short managers generally underperforming cash but significantly outperforming their relevant equity market. The average long/short fund declined 3.65 per cent versus a 17.83 per cent fall for the World index in dollars in 2001. But, since the start of 1994, the average long/short fund has generated an annualised return of 13.13 per cent with lower volatility than the 6.18 per cent return of the World index in dollars. Strategy aim A long/short equity manager’s aim is to reduce, but not to eliminate, market exposure, preserve capital and generate positive returns in falling markets. They seek to profit by investing in stocks that are likely to rise in value and selling short stocks that are expected to fall in value. Long/short managers are nimble and can often shift the focus of their portfolios by moving between value and growth, small and large cap, net long and net short, high cash and high gross exposure, and so on. Short selling allows managers to benefit from falling markets by selling shares they do not own, with the expectation of buying them back later at a lower price. The simplest form of this strategy is a “pairs” trade, which is long one stock and short another. The position size is often adjusted for the market price sensitivity of both the long and the short position. The position seeks to obtain return from the positive performance of the long and the decline in the market price of the short. This should substantially reduce the market directional element of any return. The portfolio can then be diversified by adding pairs positions. As these transactions use little capital, focus on liquid stocks and result in a diversified portfolio with less volatility than a portfolio of long stocks, leverage can be applied to enhance the returns. While global long/short funds exist, most are regional or sector-specific. Short positions Fund managers use short selling techniques by working with a prime broker, typically bulge bracket investment banks. The prime broker provides banking facilities and, most importantly, can lend shares they want to sell short. When selling short, a manager will typically borrow shares from the prime broker, for which they will pay a stock loan fee. At the same time, they will sell the shares in the market. The proceeds are deposited with the prime broker and receive interest. The manager will buy back the shares to crystallise any profit or loss. The long/short fund is the bedrock of the hedge fund sector. Many other strategies are available to investors, making the creation of a sensibly diversified portfolio eminently possible for those with the large amounts of capital required. For the rest, funds of hedge funds have proven to be a good substitute. * Source: CSFB Tremont, MSCI World Jamie Murray is product development manager at HSBC Republic Investments