CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

36.1 VARIATIONS WITHIN EQUITY LONG/SHORT FUNDS

Fundamental equity long/short, typically referred to as long/short, is an investment strategy associated with hedge funds whose managers buy equities that are expected to rise in value and sell equities that are expected to fall in value. This strategy is typically implemented through fundamental stock selection and, to a lesser extent, by varying total net exposure, also known as market timing. Note that in practice, the classification of a long/short hedge fund is somewhat subjective, and therefore caution should be used when a hedge fund is categorized as such.

36.1.1 Investment Opportunity Set, Cash and Leverage, and Market Timing

Since long/short managers typically invest in stocks, the investment opportunity set is all possible combinations of stocks. For simplicity, this discussion excludes derivatives and any private investments, though some managers may employ derivatives. Given that long/short managers can buy and sell short, all combinations of long and short stock positions need to be included. Additionally, long/short managers can be underinvested and have a positive allocation to cash, or be overinvested by borrowing cash to leverage. The possible number of combinations grows very large when we consider the continuum of allocation choices across long stocks, short stocks, and cash/leverage. Moreover, long/short managers can vary their exposures across time by increasing and decreasing total leverage while holding the ...