Hedge Fund Investing Chapter 5 Part 1: Long/Short Equity Basics
Long/short equity is the most popular hedge fund strategy. It’s also the oldest. The very first hedge fund, started by Alfred Winslow Jones in 1949, was a long/short equity fund. He turned $100,000 into $4.8 million over 20 years. People noticed. By 1968, the SEC counted 140 funds copying his approach.
Then the 1973-1974 crash wiped most of them out. Jones’s own fund dropped from $100 million to $25 million. The strategy went quiet for a while.
Why This Strategy Got So Popular
In the early days, most hedge fund money went into global macro funds. Rich individuals liked the drama and the big swings. Long/short equity was considered boring by comparison.
That changed in the late 1990s. Institutional investors like pension funds and endowments started paying attention. Why? Because traditional long-only managers kept failing to beat their benchmarks. Academic studies had been saying this for decades. Most active managers couldn’t beat a simple index fund consistently.
Long/short equity offered something different. Same asset class (stocks), same analysis tools, but with the ability to short sell and use leverage. Institutional investors understood the concept. It was basically long-only investing with extra tools.
The numbers backed it up. During the Gulf War (1990-1991), the S&P 500 dropped 14.69%. Long/short equity funds gained 5.10%. During the Russian debt default in 1998, long/short equity beat the S&P by 710 basis points. During the dot-com crash (2000-2002), the S&P fell 44.73%. Long/short equity lost only 10.30%.
By 2001, more than 50% of all hedge funds were some variant of Jones’s original model. Assets grew from $14 billion in 1990 to $276 billion by 2000 to $680 billion by end of 2010.
The Five Flavors
Long/short equity is not one thing. It comes in several styles:
- Long biased - Mostly buys stocks, uses minimal short selling. Looks a lot like traditional investing but with some extra flexibility. Measured against a market index like the S&P 500.
- Variable bias - Shifts between net long and net short depending on market conditions. More flexible, more opportunistic. Classic names here are Maverick, Lone Pine, and Tiger Management.
- Equity market neutral - Keeps roughly equal dollar amounts of long and short positions. Target is near-zero market exposure. Wants pure alpha with minimal beta. Think AQR, Two Sigma, Renaissance Technologies, D. E. Shaw.
- Risk arbitrage - Buys the target company in a merger and shorts the acquirer. Profits from the deal spread. Concentrated portfolios, sometimes fewer than 20 positions.
- Event-driven - Bets on corporate events like bankruptcies, spinoffs, or activist campaigns. May hold as few as 4 or 5 positions at a time.
Each style has different return targets. Long biased wants to beat an index. Variable bias wants alpha with lower volatility than the market. Market neutral wants absolute returns regardless of market direction. Risk arbitrage historically targeted 2-3x the risk-free rate, though in low-rate environments it’s more like mid-to-high single digits.
How These Funds Are Organized
Most long/short equity funds are run by a single founder who acts as CEO and CIO. There’s usually a COO and CFO handling operations, a director of research with sector-focused analysts, and a head of investor relations.
But the staffing needs vary by strategy:
- Long biased needs deep research staff organized by industry. Not much need for securities lending specialists since they rarely short.
- Variable bias needs everything the long biased fund needs, plus people who can find good short ideas, manage borrowing costs, and handle margin financing.
- Quantitative market neutral needs PhDs, programmers, database admins, and electronic trading expertise. These are tech companies that happen to trade stocks.
- Risk arbitrage needs senior bankers with deep Wall Street relationships, especially for borrowing securities on short notice.
- Event-driven needs legal expertise, regulatory contacts, and the ability to run activist campaigns.
Larger funds also have their own trading desks and dedicated risk managers. An equity long/short fund might trade hundreds or thousands of stocks, each with its own dividends, corporate actions, and expiration dates. The operations team has to track all of it.
The Investment Process
Most long/short equity managers follow a 10-step process:
- Evaluate macro and monetary conditions
- Assess trends in specific geographies or industries
- Estimate sector growth and profitability
- Do bottom-up research on specific companies
- Build cash flow and earnings models
- Evaluate management quality and competitive positioning
- Run quantitative and technical analysis
- Set entry/exit points and stop-losses
- Size positions based on risk, concentration, and liquidity limits
- Rebalance based on changing conditions
Before any idea goes to the investment committee, the trading desk and risk manager weigh in on position sizing. Typical constraints: no single stock more than 5% of the fund, no single industry more than 10-25%, limits on daily trading volume exposure.
Variable bias managers aim for about 80% of S&P 500 returns with less than half the volatility. They’ll typically cap individual positions at 10% of the fund. Classic equity market neutral funds go further and try to keep net market exposure within plus or minus 10% of AUM.
Quantitative funds are different. No human picks stocks. Computer models identify temporary mispricings across thousands of securities. No single position exceeds 1% of the portfolio, so you’re looking at 100+ positions minimum. Very high leverage, very low target returns per trade.
How Profit and Loss Works
Every long/short equity fund generates P&L from the same basic mechanics:
- Rising prices = profit on longs, loss on shorts
- Falling prices = profit on shorts, loss on longs
- Long positions earn dividends and pay financing charges
- Short positions pay dividends to the lender and incur borrow fees
- Short sale proceeds earn interest income
Key exposure metrics that funds report to investors:
- Gross exposure = long market value + short market value, as percentage of AUM
- Net exposure = long market value minus short market value
- Beta-adjusted exposure = same calculations but weighted by each position’s beta
For example, a $500 million fund with $120 million long and $80 million short has 200% gross exposure and 40% net long exposure.
The book walks through detailed numerical examples for each strategy type using a hypothetical $500 million fund. The results assuming the S&P returns 15% for the year:
| Strategy | Gross Return | Net Return | Net Exposure | Beta |
|---|---|---|---|---|
| Long biased | 22.23% | 16.18% | 112% long | 143% |
| Variable bias | 22.50% | 16.40% | 40% long | 66% |
| Market neutral | 11.29% | 7.43% | 4% long | 9% |
| Risk arbitrage | 22.03% | 16.02% | 13% long | 123% |
Trading profits were nearly identical for three of the four strategies. The big differences show up in net exposure and beta. Variable bias delivered slightly higher returns than long biased, but with much less volatility (beta of 0.66 vs 1.43). Market neutral had the lowest returns but essentially zero market risk.
All examples assumed a standard “2 and 20” fee structure (2% management fee plus 20% of profits).
The takeaway here is straightforward. These strategies all trade stocks. But the way they construct portfolios, manage risk, and use leverage creates very different return profiles. Same asset class, very different outcomes.
Previous: Chapter 4 | Next: Chapter 5 Part 2
This is part of a series retelling of “Hedge Fund Investing” by Kevin R. Mirabile.