Investment Strategies of Hedge Funds

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Long/Short Equity

Buy cheap and sell expensive Old Stock Exchange adage

The long/short equity strategy is the portfolio management approach that most resembles the one originally followed by the first hedge fund. Like A.W. Jones, the father of hedge funds, long/short equity managers aim at setting up an equity portfolio whose returns are not correlated to market performance, but rather to their stock selection skills. They look for shares that they believe the market is undervaluing, as well as shares they perceive are being overvalued, then they buy the first (long position) and short sell the second ones (short position). The portfolio can also be hedged without resorting to short selling, namely by using equity index derivatives: often managers sell equity index futures so as to be able to change the portfolio’s exposure rapidly in response to market changes.

Long/short equity managers make money when long positions go up and short positions go down; if the reverse occurs, they suffer losses.

Managers who adopt this strategy make use of the same fundamental, technical and statistical analyses employed by traditional equity managers and trade on the same reference market. A hedge fund, however, is structurally distinguished from a traditional mutual fund by short selling, leverage and the manager’s incentive system.

The concept in itself is easy to understand and fairly easy to implement: however, money management lies halfway between being art and science, and so the challenge ...