One of the difficulties you might encounter while trading could be determining whether a fund is long or short. This article aims to remove that confusion and helps you identify long or short funds. So, if you are among those who had difficulties determining the nature of funds, this is for you – read on.
What Is a Long/Short Fund?
Before you can determine which is a long or short fund, you must know what a long/short fund is. In simple words, a long/short fund is a type of mutual/hedge fund holding both long and short positions in investments. These investments are typically from a particular market segment. These funds frequently use various alternative investing techniques such as derivatives, leverage, and short positions to buy comparatively undervalued securities and to sell overvalued ones.
Long/short funds are sometimes referred to as enhanced funds or 130/30 funds.
- These funds make use of an investment strategy that chooses a long position in under-priced stocks and opt for selling short the overpriced shares.
- Long/short looks to improve the traditional long-only investing tactic by taking advantage of profit opportunities from both under-valued and over-valued stocks.
- Long/short equity is generally used by hedge funds that take a relative long bias. For example, it pursues a 130/30 strategy where the long exposure is 130% of AUM and the short exposure is 30%.
Long and Short Positions
Long – In the trading parlance, taking a long position in a stock means buying the stock. If the value of the stock you bought rises in value, you will make money.
Short – Taking a short position is akin to borrowing a stock you don’t own. You often buy the stock from your broker, and then sell it in the expectation that it will decline in value. When the price falls, you will be able to buy it back at a lower price than you paid for it and to return the borrowed shares to your broker.
Making Profits from Long/Short
Essentially, this strategy involves buying an undervalued stock and shorting an overvalued stock. What the fund manager anticipates is for the long position to increase in value, and the short position to decline in value. If that happens, and if the positions are of equal size, the fund will earn profit.
One of the reasons for the popularity of this strategy is that it is viewed as a less risky investment method. It is a strategy that works well as long as the long position outperforms the short position. Even if the long position actually declines in value, it will not matter.
The Fundamentals of a Long/Short Fund
Long/short funds usually aim to increase the earnings by investing in a particular market segment by actively taking both long and short positions in stocks. Long/short funds use variable active management techniques to determine the portfolio holdings. They are likely to use strategies such as leverage, derivatives, and short positions that could result in higher returns even though there is also an increased risk element.
The long/short funds share some similarities to hedge funds. They strive to offer investment strategies with greater potential returns over standard benchmarks even though they also come with greater risk. Almost all long/short funds offer higher liquidity than the hedge funds. They also do not have any lock-in periods and attract lower fees.
Nonetheless, these funds have higher fees and less liquidity when compared with most mutual funds. Long/short funds might require higher minimum investments than mutual funds. Long/short funds are also closely regulated than hedge funds and hence, they have certain limitations on the use of leverage and derivatives whereas hedge funds do not have these.
Long/short funds are an excellent investment option for investors looking for targeted index exposure with some degree of active management. These funds also have the advantage of hedging against the changing market conditions and other trends that can be accounted by active management.
Understanding the 130-30 Strategy
The most common long/short strategy is to follow the approach of long 130% and short 30% of assets under management. For a 130-30 strategy, the investment manager will rank the stocks used in the S&P 500 from best to worse. The ranking is based on expected returns and their past performances. The manager will use several data sources and rules for ranking individual stocks. Typically, the fund managers rank the stocks corresponding to few selection criteria such as total returns, risk-adjusted performance, or relative strength over a specified look-back period. This could be anything ranging from six months to a year or more, depending on the situation and requirements. The selected stocks are then ranked from best to worst.
After ranking the stocks, the manager would invest 100% value of the portfolio. The manager then short sells the lowest ranking stocks, valuing up to 30% of the portfolio’s value. The returns earned from the short sales would then be reinvested into top-ranking stocks, thereby facilitating greater exposure to the higher-ranking stocks.
Some Examples of Long/Short Funds
The performance of long/short funds usually vary from year to year. Even the best funds in a particular year might lag behind in another year. ICON and River Park were two of the top-performing long/short funds in 2017. However, in 2020, they lagged behind their peers. Nevertheless, they offer a great insight into what long/short funds do.
Let us now take a closer look at these two:
ICON Long/Short Fund
ICON Long/Short fund had a year-to-date performance of 25.96% in 2017. This fund’s investment universe included all equity securities traded in the U.S. market. It uses the S&P 1500 Index as its benchmark. The fund employs quantitative analysis to identify undervalued and overvalued securities in its investment universe. After that, it takes long positions in stocks which the fund manager believes to be undervalued and short positions in stocks which are considered to be overvalued.
RiverPark Long/Short Opportunity Fund
RiverPark Long/Short Opportunity Fund was another top-performing fund in the category in the year 2017, with a return of 24.07%. The Fund used a proprietary investment strategy for identifying undervalued and overvalued securities in its universe. It offers a transparent framework for its portfolio holdings. This fund primarily invests in U.S. equities across the whole market capitalisation and sometimes invests in foreign equities. It looks to buy undervalued companies and take short positions on overvalued companies. The fund generally holds 40 to 60 long positions and 40 to 75 short positions.
Points to Remember
- 130-30 Strategy – This is a strategy that uses financial leverage by shorting under-performing stocks and purchasing alternate shares with higher expected returns.
- Market Neutral – This is a risk-minimising strategy that involves a portfolio manager picking long and short positions, so they gain in any market direction.
- Understanding Long-Short Equity – This is an investing strategy where you take long positions in securities that are projected to appreciate and short positions in stocks that are likely to decline.
- Net Exposure – It is the difference between a fund’s short and long positions and is expressed as a percentage.
- Relative Value Fund – It is a fund that uses an investment strategy to actively earn returns that exceed specific benchmark, such as an index.
- Enhanced Index Fund (EIF) – This fund seeks to increase the returns of an index via active management to adjust the weights of holdings for added returns.
The Advantages of Long/Short
✅Several investors focus on selecting winning strategies for long portfolios. However, long/short strategies and the strategy of selling short, frees them to take advantage of a far wider range of securities.
✅The effective management of a fully integrated portfolio of long and short positions will result in increased returns, even during difficult market conditions.
Disadvantages / Problems of Long / Short
❌To earn profit, the fund manager must be able to predict the stocks that will perform well with greater accuracy. This requires making intelligent use of research and the available information.
❌A fund manager must realistically estimate and hedge the risks to the portfolio.
❌A fund should be able to manage unsuccessful short positions actively.
❌Lower liquidity when compared with mutual funds means it could be more difficult to sell shares.
❌As there is a large degree of active fund management that requires expertise, long/short funds might carry high fees.
Whatever fund one selects, due diligence should be exercised. Any funds or decisions should be opted for after careful consideration of all relevant factors. Whichever fund you trade, never enter the market without due preparation and understanding of the risks involved. The general rule has been higher the profitability, higher the chances of risk. So, you must choose your funds and strategies according to your risk appetite too. Now that you have understood long/short fund better, you will be able to take the right decision. If you do your groundwork, you are more likely to succeed.