When employing a long-short equity strategy, investors take long positions in short positions in stocks they believe will fall in value. The goal of a long-short equity strategy is to profit from price increases in long holdings and decreases in short positions in the stock market.

The technique should, in theory, result in a net profit, albeit in practice, this may not always be the case. Many hedge funds use a market-neutral approach, holding equal dollar amounts in long and short positions since this method allows them to take advantage of the popularity of the long-short equity strategy.

The Mechanisms of Long-Short Equity

The goal of long-short equities is to make money regardless of whether the price goes up or down. This method seeks to profit from price discrepancies by buying undervalued shares of stock and selling pricey shares short. Although many hedge funds use a long-short equities strategy, a smaller number of hedge funds use a long-short strategy with a short tilt.

Finding successful short ideas has traditionally been more challenging than finding successful long ideas. There are several ways in which long-short stock strategies can be distinguished from one another, including market geography, industry focus, investing ethos, etc.

A Performance Analysis of Long-Short Equity Funds

The long-short investment allows businesses to make money off both growing and declining share values, rather than just one or the other. Long-short funds outperform traditional mutual funds by taking advantage of the inherent correlation between long and short holdings. The fund will most likely make some good investments while some bad ones.

Theoretically, the long-short portfolio will allow the investor to reduce the likelihood of suffering severe losses; nonetheless, it is still possible for the investor's capital to be completely lost if poor investment decisions are made.

In other words, the lower risk of long/short investing comes at the price of lesser potential profits because it attempts to profit from both upward and downward changes in the pricing of shares.

Equity Long/Short vs. Equity Market Neutral

Compared to a long-short equity fund, an equity market-neutral fund does not aim to profit from fluctuations in the stock market by going long or short on any individual stock. Keeping the value of long and short positions equal is one way for an EMN strategy to reduce risk. Equity market-neutral funds need to rebalance when market movements gain momentum to keep their long and short positions balanced.

Equity market-neutral funds actively stifle returns and increase the size of the opposite position. In contrast, other long-short hedge funds allow gains to run on market movements and even leverage up to enhance them. Equity market-neutral funds reduce the size of their position in the market when it's expected to win and reinvest the savings into their portfolio when they are expected to lose.

Pair Trading as a Long/Short Equity Example

The "pair trade" is a common deviation from the traditional long-short paradigm in which a long position in one company is balanced by a short position in another stock within the same industry. An investor in the technology sector may short Intel to balance off a long position in Microsoft.

For example, if an investor purchases 1,000 Microsoft shares at $33 a share and Intel shares are selling at $22, the short leg of this paired trade would include purchasing 1,500 Intel shares such that the dollar amounts of the long and short positions are equal. This long-short approach would work best if Microsoft rose in value and Intel fell.

There would be a $3,500 profit if Microsoft reached $35 and Intel dropped to $21. However, the approach would still be lucrative at $500, albeit at a much lower rate, if Intel rose to $23, as the same forces tend to move equities up or down in a certain industry.

Impact on Private Investors

There are advantages and disadvantages to a long-short stock strategy. Investing in both long and short positions might assist create a portfolio with a lower correlation to market fluctuations. They can potentially outperform the market in terms of returns.

While this approach can reduce the likelihood of loss, it does not guarantee complete safety. In general, long-short equity funds have greater expenses than traditional mutual funds, which private investors should keep in mind. Naturally, higher costs might cut into your earnings.

While the typical mutual fund has a gross cost ratio of roughly 0.54%, Guggenheim's Long Short Equity Fund charges 1.75%.