Long-Short Equity: Playing It Safe in Hedge Fund Investment
Hedge funds face less regulation than mutual funds. They are high-risk investments that are not for the meek. In a nutshell, a professional fund manager (general partner) manages a hedge fund, while investors (limited partners) finance it. These funds enjoy more freedom, such as having the ability to buy other assets besides stocks and bonds (ex: fine art and rare earth metals); investing in distressed securities, and borrowing money to amplify returns.
As such, the US Securities and Exchange Commission (SEC) advises that companies and private funds only invite accredited investors to contribute to their fund. To reduce risks and open more channels for returns, hedge fund managers engage in long-short investing.
The Goal of Absolute Returns
In long-short equity, the fund manager invests half of the capital to take long positions on stocks that are projected to increase in value. The other half goes to short positions on stocks that are expected to decrease in value.
The goal of a long-short strategy is to provide absolute returns to investors. Fund managers can do this by investing in stocks with predictable trajectories; and when the long positions gain more value and the short positions decline, the investors get maximum returns. If only one side of the portfolio moves favorably, the value could still amount to more than the underperforming book and make up for its shortcoming.
Investors and hedge fund managers can only get favorable outcomes if they know how to identify high-performing and low-performing stocks. Otherwise, they risk losing if both sides of their portfolio don’t move according to their expectations.
Observing C-Level Behavior is Key
The success of long-short equities depends on the choice of stocks. To reduce risks, fund managers can take their cues from the behavior of C-level executives. The SEC requires directors, officers, and 10% shareholders of a company should file a Form 4 report every time they buy or sell stocks in their own company. The SEC will then publicize these reports two days after.
Long-short hedge fund trading that uses Form 4 “insider information” may generate substantial returns. After all, the best indicator of a high-performing stock is the buying confidence of its shareholders. Likewise, stakeholders selling their shares is an indicator that the company’s performance is below expectations.