A hedge fund can be explained to be a private partnership which invests in heterogeneous investments with an aim to maximise expected returns while reducing risk (Kourbetis, 2010). They are speculative investment vehicles which are designed to utilize the high-quality information that is possessed by their managers. It is also generally defined to be an “actively managed, pooled investment vehicle” which is open to only a limited set of investors and that which generates absolute kind of returns. (Connor et al, 2003).
GROWTH OF HEDGE FUND INDUSTRY
2013 was a year of strong return of investor confidence in the hedge funds industry. The Prequin Report (2014) reports that the most established country in the hedge fund industry is the USA followed by UK. 60% of the fund managers of the world are located in USA and approaximately 21% of the managers are in the U.K. Hedge fund assets have grown more than $ 360 Billion over the year taking the total assets number past the $ 2.6 Trillion mark (Prequin Report, 2014). Assets Under Management (AUM) of UK approximates to a total of $ 440 Billion (17% of world-wide total).
According to the Neuberger Berman Report (2014), the long-short equity hedging strategy is returning to “alpha” bent returns as the correlations between stocks are showing a declining trend globally and have stayed at these levels of moderation from late 2012. According to HFR (2014) HFRX Equity Hedge Index showed a rise in performance by 11.14% in 2013 over 2012. The following graph shows the rolling one-year stock correlations vs HFRX equity index: Lower correlations help managers as this implies a raise in the importance of company fundamentals to the stock performance. Some of the top performing hedge funds with long-short equity hedge trading strategies include Blackrock, Marshall Wace, etc.
WHAT IS LONG SHORT EQUITY HEDGE STRATEGY
Fung et al (1997) classified a hedge fund’s strategy in terms of their style and location. Style refers to the asset position that a fund manager takes eg. going short, long, staking on a specific type of corporate event, retaining market neutrality, etc. Location would mean the asset class that a hedge fund normally invests in like fixed income securities, equity, currencies, etc.
Another way of classifying funds is according to their nature. Market neutral funds refer to those funds which are not much impacted by variations in the overall market returns ie they have a low level of correlation with the return of the overall market. Directional funds share a high correlation with overall market return due to their very nature of taking stakes on movements in the market (Connor et al, 2005).
Barclay Hedge (2014) explain equity long-short strategy as an strategy for investment , primarily used in hedge funds which takes long positions in stocks which the manager expects to result in an increase and taking a short position in a stock which the manager expects to reduce in value. Taking a long position in a stock refers to buying a stock, which would result in a profit, if the price increases tomorrow. Taking a short position in a stock would refer to a situation where stocks are borrowed and sold in the market, hoping the stock to decline in value in the future. When the stock declines, the shares will be bought and returned back to the lender of shares.
If the size of these positions taken are equal in value and the expected market movements occur, the hedge strategy results in a profit to the fund. This will be advantageous even if there is a decline in the market trends, if the fall in the long position is lesser than that in the short. That is the short position has to be outperformed by the long position. Accordingly, the aim is to minimize the exposure of risk to the unpredictable movements in the market and also to make the most from the spread i.e. differences in the prices between stocks.
Connor et al (2005) also explains a long-short equity type of strategy. He explains that the fund manager can take advantage of both over-valued as well as under-valued securities. He can fully concentrate on selection of securities to get absolute returns. At the same time, he can also reduce his market risk exposure by offsetting long and short positions. This provides additional leverage to such kind of portfolio.
This can be understood better with the help of a hypothetical example. Suppose the manager takes a £ 1 Million long on GlaxoSmithKline PLC (GSK) and £ 1 Million short on Astrazeneca PLC (AZN), both of which are large pharmaceutical companies listed on the London Stock Exchange. Given these positions if the market dips, it will result in a loss on GSK and a gain on AZN. On the contrary, if the market rises, there may not be much effect as both the positions may balance out each other.
So, the actual reason why the investor would take such positions would be because he thinks that GSK would perform better than AZN going by the actual company fundamentals. Such strategies with equal dollar long and short positions are called market neutral strategies. Not all managers would go for neutral strategies. Some managers would retain a long bias, called “130/30” strategies wherein the manager would hold an exposure of 130% in long positions and 30% to short. These prove to be very advantageous when the markets are continuously showing a rising trend. Some managers may also resort to having a dedicated short bias when the markets show a continuously declining trend.