Long & Short Hedge Fund Analysis
Hedge funds are limited partnerships that invest in a wide range of financial products, including stocks, bonds, derivatives, currencies, commodities and other hedge funds. Investors include wealthy individuals, endowments and pension funds. Hedge-fund managers employ different strategies to maximize returns. These include event-driven investing, which takes advantage of restructurings and other unique opportunities, and long-short investing, which invests in both long and short positions.
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Basics
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A long-short strategy involves taking simultaneous long and short positions in the market. Long positions involve buying stocks, while short positions involve borrowing stocks from the broker and selling them in the hope of buying them back later at a lower price. The long positions usually rise and fall with the markets, while the short positions move in the opposite direction. Research cited on the Deutsche Bank Absolute Return Strategies Research whitepaper showed that long-short hedge fund managers outperformed the Standard and Poor's 500 by as much as 10 percent over the period between 1990 and 2003.
Role
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Equity long-short funds allow investors to hedge their risk exposures to, and potentially profit from, market downturns. However, a long-short strategy is not necessarily a market-neutral strategy -- which invests in equal dollar amounts of long and short positions -- because these funds have demonstrated a strong correlation to overall market performance. In other words, these funds tend to rise and fall with the markets in spite of their short exposures. In fact, if a fund manager times his positions incorrectly, meaning that he increases his short positions just before the market starts to rise or increases long positions before a market drop, the fund could suffer significant losses.
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Strategies
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According to the BarclayHedge website, hedge-fund managers generally employ a long bias, which means holding more funds in long positions than in short positions. Few long-short funds maintain a short bias for long periods because equities generally move up over the long term. However, managers can increase their short allocations to respond to market downturns. Hedge-fund managers should usually carry less than 50 percent in long positions to guard against market declines.
Risks
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Hedge funds generally are not as liquid as mutual funds. At the time of publication, hedge funds do not have to register with the United States Securities and Exchange Commission. Hedge-fund managers may employ risky investment strategies, such as leverage, which could mean significant losses. Equity long-short funds have additional risks, such as greater losses in long positions when there is a sharp market drop and the reliance on a manager's ability to select the right securities for the long and short positions.
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