Introduction to Equity Long/Short Strategy

When the words hedge fund are used, most people associate it with the long/short equity strategy.  The fund manager constructs a portfolio of stocks in two components:  long positions in attractive/undervalued stocks and short positions in unattractive/overvalued stocks.  Additionally, there can be positions in derivatives such as stock options, index options or index futures.

Managers specialize in three distinct areas:  concentration, market capitalization and geography.  Concentration relates to the sector of the stocks.  Market capitalization is the size of the company and geography is the region/country of the company.  A manager can specialize in one sector, market cap or region/country or across multiple sectors, market caps or regions/countries.

Managers may use fundamental or quantitative stock picking strategies.  The traditional fundamental strategy involves knowing a company inside and out when making an investment decision.  This includes financial statement analysis, talking to company officers (such as the CFO), learning about the company's industry, gathering intelligence on the company from conferences and meeting with the company's day-to-day points of contact (such as their clients, vendors, supply providers, competitors, etc.).  The analyst or manager collects this data and forms an opinion of the company's prospects based on the mosaic theory.  Hedge funds mainly concentrate on mid and small cap stocks because they have limited coverage from the sell side.  A large cap company such as Coca-Cola has many analysts covering it and lots of public information available compared to a mid or small cap company.  In the latter case, there is a better opportunity to spot an undervalued and underappreciated stock price.  The sell side institutions base their business model on this strategy.  Many hedge funds and a majority of mutual funds use it.

Another fundamental strategy is known as the top-down approach.  Here managers study the economic drivers to forecast the prospects for different sectors of the economy.  From here, they would predict how individual companies would fare.  They would look at statistics such as Gross National Product, inflation, interest rates, import/export figures, etc.

The quantitative approach uses factors as a way to screen out unsuitable stocks for investment.  Some examples of factors are P/E ratio, price to sales ratio, price to book value ratio, etc.

Technical analysis can be used for the price momentum strategy.  Managers may use price charts to find stocks that are outperforming or underperforming the market and establish long or short positions.

Those are the mainstream long/short strategies.