Long Short EquityHedge Funds
Long Short equity hedge funds trade shares for their profit. They use equity positions alongside equity targeted options and futures to profit from positive (long side) and negative (short side) price movements. During positive movements funds simply buy and gain profits. During negative movements funds sell and initiate short sales. Funds may mix long and short positions, to reduce risks stemming from market movements against certain trades. Even if they are engaged in hedging they will not perfectly reduce risks stemming from sectors, regions, and industries selected.
These funds are similar to mutual funds, but without their limitations. Mutual funds are not allowed to use leverage, options, futures, or short sales due to regulations. Hedge funds are unrestricted, giving them substantial advantages in decreasing equity risks while creating profits. Long and short equity funds often come in flavors. Some funds have global outreach; others focus only on certain industries, market sectors, regions, or nations.
Single or Multi-Directional Options
Hedge funds in this category can also be long or short equity only. Many funds only trade one directional side. Long equity funds only exist to purchase and hold shares, while short equity funds only short sell shares. Both funds can use leverage and derivatives to accomplish their goals. The risk for these equity fund types is asymmetrical. Long funds only risk their purchases falling to zero, while short funds can lose infinite amounts of money if the share kept rising while the short was left open. Short selling is far more dangerous, and typically isn’t a primary plan.
The funds which partake in both long purchase and short sales should not be confused with arbitrage funds. Arbitrage funds will use long and short positions on two varieties of the same or related asset as their primary strategy. Long and short hedge funds will target differing assets, purchasing undervalued shares while shorting overvalued shares. Arbitrage oriented funds also are far less concerned with directional movements. Arbitrage returns come from prices converging at a central value instead of market directions. This does not mean long and short equity funds never use arbitrage, only that it is not their primary focus. Funds may take long positions, short positions, pair trades, arbitrage and other strategic actions.
Long Short hedge funds are weighted in different directions based on the positions they have taken. While many funds attempt to remain market neutral which generates returns regardless of market direction, long and short funds gain returns based on the compatibility of the market’s directional movement and their market bias. If they have more long positions than short positions, the fund is stated to have a long net bias. If they have more short positions than long positions, the fund is stated to have a short net bias. A long bias is better than short bias during a bull market. The same can be said of a short bias during a bear market. These statements are made with a caveat: They depend strongly on the individually selected investments. Poor individual selections override an appropriately selected bias.
Funds engaged in Long Short equity have other plays they can attempt, including pair trades. This play is similar to arbitrage, but differs in one substantial way. Pair trades select shares which are within the same sector or industry, and purchases undervalued shares while shorting overvalued shares. Arbitrage uses multiple assets or the same asset which derives their value from the same underlying firm, but has moved out of line relative to each other or the same asset.
Long Short equity funds may have categorizations. They may also be split into share capitalizations. Capitalizations split into large cap of over $5 billion, mid cap of $1 billion to $5 billion, small cap of $100 million to $1 billion, and micro-cap of under $100 million. Lower capitalizations typically have more growth and more room for growth, while higher capitalizations typically have more stability. Capitalizations can be somewhat fluid, so you may ask if the fund has defined ranges in which they trade.
Derivatives and Funds
Long Short equity hedge fund managers, no matter which play they use, will often boost performance with options and derivative instruments. If options sold are not used, they may boost performance by earning premiums. If options are sold out of the money and used, they secure a purchase or sales price managers select in advance. Funds can also purchase long or short equity options to have the right to purchase or sell desired shares, which they may exercise based on market price directions.
Potential Investment Overlaps
Since Long Short hedge funds primarily trade shares, this type of hedge fund is highly likely to overlap with equity based assets in your portfolio. Your long and short hedge fund should not target the same sector, industry, or region as your mutual or index fund investments. Overlaps concentrate your sources of return and risk, hurting you in downward price swings. Avoid overlapping investments in funds beyond your control, since you won’t be able to reduce holdings of the overlapping shares without completely exiting a fund.
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