Long Short Fund Definition Strategy and Application Explained

Core Description

• Long/Short Funds are investment vehicles that utilize both long positions (buying undervalued assets) and short positions (selling borrowed overvalued assets) to generate returns regardless of market direction.
• Key concepts include gross and net exposure, leverage, liquidity limits, and careful risk management to control both market and idiosyncratic risks.
• These funds require deep research, robust governance, and prudent sizing to deliver alpha and manage downside risk across market cycles.

Definition and Background

A Long/Short Fund is a type of investment vehicle that simultaneously holds long positions (securities expected to appreciate in value) and short positions (securities expected to depreciate in value). The main objective is to generate returns that are less dependent on the overall direction of the market and more influenced by the manager’s security selection skills, commonly referred to as alpha.

Historical Development

Long/short investing concepts originated in the early 20th century, shaped by academic and trading pioneers such as Keynes and Benjamin Graham. In 1949, A.W. Jones is credited with establishing the world’s first formal hedge fund, combining long equity selection, short selling, and leverage. His approach aimed to separate the value added by manager skill (alpha) from general market exposure (beta).

During the 1970s and 1980s, the strategy gained broader adoption with advances in derivatives and prime brokerage, making shorting more practical. In the 1990s, the introduction of factor models and quantitative strategies enabled more accurate hedging and exposure management. Following the market crises in the late 1990s and in 2008, requirements around regulation, transparency, and risk management increased significantly.

Currently, long/short funds are available in various formats, including mutual funds, UCITS, and hedge funds, and cover equities, credit, commodities, and macro assets. Strategies are tailored according to regional regulation and investor demand.

Core Terminology

• Long Position: Buying an asset expected to rise in price.
• Short Position: Selling borrowed assets expected to fall in value.
• Gross Exposure: The sum of the absolute values of all long and short positions.
• Net Exposure: The difference between the market value of long and short positions.
• Market Neutral: A strategy aiming for zero overall market exposure to reduce beta risk.
• Alpha: Return attributed to manager skill rather than general market movement.
• Beta: Sensitivity of the portfolio to overall market movements.

Calculation Methods and Applications

Key Portfolio Metrics

Gross and Net Exposure

• Gross Exposure = (Market Value of Longs + |Market Value of Shorts|) / Net Asset Value (NAV)
• Net Exposure = (Market Value of Longs – |Market Value of Shorts|) / NAV
  • Example: If a fund holds $120 in long positions and $60 in short positions, Gross = ($120 + $60)/$100 = 180%, Net = ($120 – $60)/$100 = 60%.

Leverage

• Leverage Ratio = (Longs + |Shorts|) / NAV
• Leverage limits are generally guided by regulatory and internal risk control policies.

Risk Metrics

• Volatility (annualized): Standard deviation of daily returns scaled by √252.
• Sharpe Ratio: (Expected return – Risk-free rate) / Volatility.
• Information Ratio: Measures manager skill by dividing excess returns over a benchmark by the standard deviation of those excess returns.

Performance Attribution

• Alpha and beta are typically estimated by regressing portfolio returns against a relevant benchmark.
• Portfolio risk contributions can be further attributed to exposure to specific factors (such as value, size, momentum) and idiosyncratic elements.

Return Calculation

• Daily P&L = Σ (Long_MV_previous_day × Return_today) + Σ (–|Short_MV_previous_day| × Return_today) – Borrowing and Financing Costs – Dividends Owed on Shorts
• Fund Return = P&L_today / NAV_previous_day
• NAV_today = NAV_previous_day × (1 + Return_today)

Example Application (Hypothetical)

Assume a manager oversees a $100,000,000 fund with $150,000,000 in long exposure and $130,000,000 in short exposure. If long positions gain 2 percent and short positions decrease by 1 percent (ignoring costs):

• Long gain = $150,000,000 × 2 percent = $3,000,000
• Short gain = $130,000,000 × 1 percent = $1,300,000 (the fund gains when shorts decline)
• P&L = $3,000,000 + $1,300,000 = $4,300,000, equating to a 4.3 percent return on a $100,000,000 NAV

In actual scenarios, returns must account for borrowing costs, leverage constraints, and liquidity conditions.

Comparison, Advantages, and Common Misconceptions

Advantages of Long/Short Funds

• Potential for Positive Returns in Various Market Environments: By holding long positions in strong securities and short positions in weak ones, managers can target alpha across rising, falling, or sideways markets.
• Risk Hedge: Short positions can decrease net market exposure, helping reduce portfolio volatility and drawdowns in adverse markets.
• Broader Opportunity Set: The flexibility to profit from mispricing on both sides (long and short) allows for more diversified strategies, including pair trades and relative value trades.
• Diversification: Including long/short strategies alongside traditional investments may reduce overall risk and improve risk-adjusted outcomes.

Disadvantages and Risks

• Dependence on Manager Skill: Performance relies significantly on the skill in selecting both long and short positions and managing risk.
• Higher Fees and Costs: These strategies often charge performance and management fees and incur borrow fees and dividend obligations on short positions.
• Shorting Risks: Short positions can theoretically incur losses greater than the initial investment, are susceptible to short squeezes, and can face borrow recalls.
• Operational Complexity: Management requires advanced risk systems, robust processes, and ongoing oversight.

Common Misconceptions

Myth: All Long/Short Funds Are Market Neutral

Not all long/short funds aim for net-zero or beta-neutral exposure. Some pursue intentional directional risk to align with market trends.

Misconception: Shorting Simply Doubles Upside

Short gains are capped (maximum 100 percent if a security declines to zero) but potential losses can be much larger. Borrowing costs and recall risk also impact outcomes.

Error: Overlooking Borrow Costs and Short Squeeze Risks

Borrow fees may rise due to increased demand or reduced shares available, eroding expected profits. Instances like the 2021 GameStop event demonstrate that short squeezes can cause major losses.

Confusion: Hedging Removes Drawdowns Entirely

Hedging reduces risk but cannot eliminate it fully. Imperfect hedging, market dislocations, or unexpected events (basis risk) may still lead to portfolio declines.

Overlooking: Benchmark Selection

Evaluating long/short funds against long-only benchmarks can misrepresent results, as the risk and exposure profiles differ substantially.

Practical Guide

Identifying Investment Objectives and Constraints

• Core Role: Clarify whether the long/short fund is intended for drawdown control, as a core absolute-return holding, or as a hedge for other equity assets.
• Target Metrics: Establish targets for return, risk (volatility), drawdowns, and correlation to existing investments.
• Liquidity and Rebalancing: Determine requirements for redemption frequency, lock-up periods, and portfolio rebalancing.

Strategy Selection

• Market-Neutral: Designed for low correlation with equity markets and focused on security selection and spread trades.
• Directional Long/Short: Allows for net market exposure with the aim for potential upside and reduced downside.
• Edge Source: Identify whether manager skill comes from fundamental research, factor timing, or special situations.

Portfolio Sizing and Construction

• Consider allocating 5 percent to 15 percent of the total portfolio to long/short strategies, with gradual implementation for risk averaging.
• Core-satellite structures may combine a market-neutral base with a smaller directional allocation.
• Risk controls should address position, sector, and overall leverage limits.

Case Study (Hypothetical Example)

Assume an endowment allocates 10 percent of its portfolio to a U.S.-market long/short fund targeting market neutrality. In 2022, while the S&P 500 declined by approximately 18 percent, the fund’s 160 percent gross exposure and 10 percent net exposure, supported by stock selection and sector hedging, resulted in only a 4 percent drawdown. This contributed to portfolio diversification and return stability during a broad market sell-off.

Ongoing Monitoring

• Continuously track net/gross exposure, portfolio beta, Sharpe and Information ratios, and drawdowns.
• Review risk metrics regularly and re-assess the manager’s process yearly.
• Establish clear exit criteria, such as persistent underperformance or significant changes in risk discipline.

Fee and Tax Considerations

• Analyze all-in costs, including performance and management fees, borrowing expenses, and transaction costs.
• Review liquidity terms, redemption gates, and mechanisms like side pockets.
• Seek specialist tax advice on the treatment of short positions and derivatives based on local regulations.

Resources for Learning and Improvement

• Textbooks:

  • “Active Portfolio Management” by Grinold & Kahn (covers portfolio construction and alpha theories)
  • “Quantitative Equity Portfolio Management” by Qian, Hua & Sorensen (explains short selling, portfolio constraints, and costs)
  • “Investment Science” by David Luenberger (focuses on optimization and risk analysis)

• Practitioner Books:

  • “Market Wizards” and “Hedge Fund Market Wizards” by Jack Schwager (interviews with experienced global managers)
  • “More Money Than God” by Sebastian Mallaby (on hedge fund history and associated risk stories)
  • “You Can Be a Stock Market Genius” by Joel Greenblatt (covers special situations and long/short approaches)

• Academic Journals and Papers:

  • Relevant academic articles: Jegadeesh & Titman (momentum), Fama-French (factor models), Asness et al. (value and momentum), Miller (short-sale constraints)
  • Financial Analysts Journal, Journal of Portfolio Management for studies on portfolio strategy

• Industry Reports:

  • White papers authored by industry leaders (AQR, Man Group, BlackRock) on factor investing, borrow costs, and construction techniques
  • Reports from Morningstar, HFR, BarclayHedge for strategy insights and data

• Online Courses:

  • Coursera, edX, and MITx offer modules on quantitative finance, factor investing, and risk management
  • CFA Institute credential modules on alternatives and hedge fund basics

• Data and Platforms:

  • Bloomberg, Refinitiv, FactSet supply price and borrow cost information
  • HFRX, eVestment, and WRDS provide fund performance benchmarks and analytics

• Regulatory References:

  • SEC Regulation SHO, FCA/ESMA short selling rules, and UCITS/AIFMD requirements in the EU

FAQs

What is a Long/Short Fund?

A long/short fund is an investment vehicle that takes both long positions in securities identified as undervalued (expected to rise in price) and short positions in overvalued securities (expected to fall), aiming for returns regardless of overall market conditions.

How do long and short positions work in practice?

Long positions earn profits if the price rises, and may provide dividends. Short positions involve borrowing and selling securities, repurchasing later in hopes of a price drop; note that losses can exceed initial investment.

What are the main risks for investors?

Notable risks include the potential for losses beyond initial investment for shorts, borrow recalls, risk of short squeezes, high costs, and dependency on manager expertise.

How do long/short funds differ from long-only funds?

Long/short funds can generate potential returns from both increasing and decreasing security prices and offer active exposure management. Long-only funds profit only from rising markets.

Are long/short funds always market-neutral?

No, approaches vary. Some target market neutrality with very low beta, while others hold deliberate net exposure for higher return potential.

What fees can investors expect?

Typical fee structures include management fees, performance fees, and expenses related to borrowing, administration, and trading activities.

How should long/short funds be evaluated?

Assessment focuses on risk-adjusted measures including Sharpe and Information ratios, alpha production, correlation with other assets, and performance through market cycles.

How can investors access these funds?

Availability depends on local regulation and may include mutual funds, UCITS, ETFs with long/short strategies, hedge funds (for eligible investors), and certain retail platforms.

Conclusion

Long/Short Funds play an important role in diversified portfolios for investors seeking to manage risk and enhance return potential beyond traditional long-only strategies. By combining long and short positions, these funds pursue alpha from both outperforming and underperforming securities, offer risk management techniques, and help moderate portfolio volatility across different market regimes. Successful implementation requires rigorous research, disciplined risk controls, an understanding of all exposures, and diligent manager selection. Outcomes depend on cost management, thorough due diligence, and regular performance monitoring. Whether used as a strategic core or as a portfolio component, long/short funds are versatile instruments when approached with an appreciation for their unique characteristics and risks.