Long-Short Equity Strategies 'Hedging' Your Bets

Clint Sorenson, CFA, CMT WealthShield

With US equities near record highs, investors may be seeking ways to position their portfolios for what lies ahead. It could be an opportune time to consider the inherently riskmitigating characteristics of long-short equity strategies.

As the name suggests, long-short equity strategies invest both long and short in publicly traded equities and equity-related instruments. Compared to their long-only counterparts, long-short strategies are designed to have lower sensitivity to equity market movements, as measured by beta, volatility and drawdowns. When included as part of a broadly diversified portfolio, such strategies have the potential to: (1) generate profits from their long and short positions and (2) provide an element of protection, or hedge, when markets decline because gains on short positions will dampen losses on long positions.

What is shorting? Short selling involves borrowing shares and selling them at a certain price on the assumption that the price will decline, allowing the seller to buy shares back at a lower price and return them to the owner. Short selling is only profitable when share prices decline and may be exposed to steep losses if share prices rise.

A Broad Category With A Strategy For Every Risk Appetite

A range of strategies fall under the general category of long-short equity (Display 1). In our view, the most compelling strategy in today's market environment would be a low-net or zero-net strategy, otherwise known as "market neutral." Compared to other long-short equity strategies, market neutral strategies tend to exhibit low or zero beta, lower market risk, lower market volatility and seek to generate returns through stock selection. These strategies are not designed to shoot the lights out, but they have the potential to provide steady gains even in down markets.

Long-Short Strategies Are Also Actively Managed

In addition to the potentially riskmitigating benefits of including short positions, long-short strategies typically have flexibility to adjust their risk profiles in response to changing market conditions. They are not required to maintain static exposures, nor are they tethered to a benchmark. Managers of market-neutral strategies can take a variety of steps to reduce risk and protect capital, specifically:

Reduce overall portfolio gross exposure by selling longs and covering shorts at the same time, so that the portfolio has less capital at risk.
Reduce position sizes to reduce volatility.
Incorporate portfolio protection in the form of index hedges, futures or options.

Long-Short Strategies Have Held Their Own In Prior Market Downturns

During the bear markets of 2000-2002 and 2007-2008, and the down markets of mid-2011 and late-2018, long-short equity strategies broadly, as measured by the HFRI Equity Hedge (Total) Index, and market-neutral strategies more specifically, as measured by the HFRI Equity Market Neutral Index, achieved their goal of mitigating downside risk relative to the broad markets across a variety of metrics (Display 2).

Among long-short equity strategies, marketneutral strategies have proven particularly adept at managing downside risk over time, while allowing investors to participate in up markets as well (Displays 3 and 4).

Of course, past performance is no guarantee of future results. Four main risks will always face long-short equity investors:

1. MARKET RISK: the risk of loss due to the impact of general market movements.

2. IDIOSYNCRATIC RISK: the risk of loss due to company-specific factors that are generally not correlated with the broad market movement.

3. SHORT-SALE RISK: the risk than an investment sold short generates significant losses because the stock price appreciates.

4. LEVERAGE RISK: the risk of loss due to unexpected interaction between longs and shorts or an improperly hedged portfolio.

Conclusion

Against a backdrop of the longest-running bull market in history, investors may well be concerned about the potential for weaker markets. In our view, including an allocation to market-neutral strategies in a well-balanced portfolio could provide valuable downside risk-mitigating benefits.

Download The Full Weekly Market Commentary

Author

Clint Sorenson, CFA, CMT

WealthShield

EUR/USD hits two-day highs near 1.1820

EUR/USD picks up pace and reaches two-day tops around 1.1820 at the end of the week. The pair’s move higher comes on the back of renewed weakness in the US Dollar amid growing talk that the Fed could deliver an interest rate cut as early as March. On the docket, the flash US Consumer Sentiment improves to 57.3 in February.

GBP/USD reclaims 1.3600 and above

GBP/USD reverses two straight days of losses, surpassing the key 1.3600 yardstick on Friday. Cable’s rebound comes as the Greenback slips away from two-week highs in response to some profit-taking mood and speculation of Fed rate cuts. In addition, hawkish comments from the BoE’s Pill are also collaborating with the quid’s improvement.

Gold climbs further, focus is back to 45,000

Gold regains upside traction and surpasses the $4,900 mark per troy ounce at the end of the week, shifting its attention to the critical $5,000 region. The move reflects a shift in risk sentiment, driving flows back towards traditional safe haven assets and supporting the yellow metal.

Crypto Today: Bitcoin, Ethereum, XRP rebound amid risk-off, $2.6 billion liquidation wave

Bitcoin edges up above $65,000 at the time of writing on Friday, as dust from the recent macro-triggered sell-off settles. The leading altcoin, Ethereum, hovers above $1,900, but resistance at $2,000 caps the upside. Meanwhile, Ripple has recorded the largest intraday jump among the three assets, up over 10% to $1.35.

Three scenarios for Japanese Yen ahead of snap election

The latest polls point to a dominant win for the ruling bloc at the upcoming Japanese snap election. The larger Sanae Takaichi’s mandate, the more investors fear faster implementation of tax cuts and spending plans.

XRP rally extends as modest ETF inflows support recovery

Ripple is accelerating its recovery, trading above $1.36 at the time of writing on Friday, as investors adjust their positions following a turbulent week in the broader crypto market. The remittance token is up over 21% from its intraday low of $1.12.