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source: Franklin Templeton
Equity Strategies | Long Short | Pair Trading | Risks – An equity strategies are investment strategies either for an individual portfolio or a vehicle of pooled funds such as Mutual funds or hedge funds. This strategy has a focus exclusively on equity securities for the purpose of investment, whether it is a listed stock, over-the counter stocks or private equity shares. A fund/portfolio can mix the proportion of equity while operating their strategies, whether they require following 100% Equity strategies or lesser depending on the objective of the fund. The prospectus needs to clearly specify the weight of equity in their basket of portfolio.
In this article, we discuss Equity Strategies in detail –
- Equity Strategies Considerations
- Equity Strategies – Long/Short
- Equity Strategy – Pair Trading
- Risks involved in Equity Strategies
- Equity Strategies – Fundamentalists v/s Opportunists
Equity Strategies Considerations
Generally, equities are considered to be the riskier class of assets for investing in comparison to cash and bonds, since the performance of such equities is connected with multiple macro economic factors of the economy as well the firm in which the investments have been made. However, the historical returns have proven to be higher than traditional investments such as Bank Fixed Deposits but the futuristic performance is always unpredictable.
A well blended portfolio of various stocks can protect against individual firm risk or sector risk, but market risks will always exist which can impact the equities asset class. All stock portfolios shall perform the best when the underlying economy is showing continuous signs of growth measured in terms of the GDP (Gross Domestic Product) and the inflation is in the range of low to moderate, since inflation can erode the future cash flows of equities. In addition, the tax structure will also have an impact on such strategies undertaken. For instance, if the economy imposes a 10% DDT (Dividend Distribution Taxes), it will reduce the returns obtained from equity investing which in turn impact the risk to return ratio for a portfolio.
Equity Strategies – Long/Short
Equity long-short strategies have traditionally known to be used by the niche category investors (investors having a superior status), such as institutions in existence over a large period of time. They started gaining prominence amongst the individual/retail investors since traditional strategies were unable to meet the expectations of the investors during a bearish market scenario thereby, encouraging the investors to consider their portfolio expansion towards possible customized or innovative financial solutions.
An equity long-short strategy is strategy for investment, used predominantly by hedge funds, which involves holding a long position in stocks which are expected to increase in value and simultaneous holding of short positions in stocks expected to decline in value expected over a period of time. A hedge fund manager has to be on their toes and may have to adopt such strategies simultaneously to take advantage of arbitrage opportunities or use it as a hedging opportunity.
Hedge funds perform such strategies on a huge scale. In simple terms, a long-short strategy of equities involves purchasing a stock which is relatively undervalued and sells one which is comparatively overvalued. Ideally, the long position will enhance the value of stock and short position shall lead to reduction of value. If such a situation occurs and the positions held are of equal size (e.g. going long on 500 shares and going short on 500 shares) the hedge fund stand to gain. This strategy will even work if the long (stock whose value is expected to rise) position declines in value provided this long position outperforms the short (stock whose value is expected to fall) position and vice versa.
For example, ABC hedge fund decides to hold a $5 million long (buying) position in Pfizer and a $5million short (sell) position in Novartis Healthcare which are both enormous firms in the pharmaceutical sector. With such positions held in the portfolio of ABC hedge fund, any market/firm specific event which may cause all stocks in the pharmaceutical sector to fall will lead to a loss on the Pfizer option (position held) and a gain on the Novartis shares. Similarly, an event that causes both the stocks to rise will have minimum impact, since the positions will set off each other with one stock rising and the other one falling off. It is simply using it as a hedging technique depending on the proportion of the stocks held of each company.
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Equity long-short strategies such as the above one having equal dollar amounts of long and short positions are called as “market neutral” strategies. For instance, a market neutral position may involve taking a 50% long position and 50% short position for the same amount in a single industry such as Oil and Gas. Employing such strategies is completely at the discretion of the hedge fund managers. Some managers will indulge in maintaining a long bias, like the so-called “125/25” strategies. With such strategies, hedge funds have 125% exposure to long positions and 25% exposure to short strategies. This mix can be tweaked depending on the tactics of the hedge fund manager such as “110/10”strategy or “130/30” strategy.
Equity Strategy – Pair Trading
Equity long-short managers can be distinguished on the basis of the geographic market in which the investments are tilted towards (Asia-Pacific, America region, Euro region etc), the sector in which they invest (Financial, Technology etc) or their style of investment (bulk trading etc.) Simultaneous buying and selling two related stocks- for e.g. 2 stocks in the same region or industry is called a “paired trade” model. This may pose limitation to a specific subset/sector of the market instead of a general phenomenon.
For instance, an investor in the Media space may take a long position in CNBC and offset that by taking a short position in Hathway Cables. If the investor purchases 1,000 shares of CNBC at $50 each and Hathway is trading at $25 then the short leg of this paired trade will involve purchasing 2,000 Hathway shares so that they can short the same. Hence, the long and short positions will be equal.
The ideal scenario for this long/short equity strategies to work will be for CNBC to appreciate and for Hathway to decline. If CNBC rises to say $60 and Hathway falls to say $20, the overall profit in this strategy will be:
1000*60 = $60,000 minus Purchase price of 1000*50 = $50,000, Gain = $60,000 – $50,000 = $10,000
2000*25 = $50,000 minus Selling price of 2000*20 = $40,000, Gain = $50,000 – $40,000 = $10,000
Hence, the total gain will be $10,000(Long) + $10,000(Short) = $20,000 on the entire portfolio.
To adjust to the fact, that stocks within a sector generally tend to move up or down in unison, long/short strategies should be preferred in different sectors for the long and short legs. For instance, if the economy of a country is slowing down and simultaneously the Pharmaceutical sector is expected to get some major drug approvals enhancing the entire industry, then the ideal portfolio strategy will be to buy equities of a firm in the Pharma sector and go short on finance company equity.
Risks involved in Equity Strategies
Equity strategies including long-short one are prone to various kinds of risks:
- Hedge funds are not very liquid as compared to various mutual funds since they make bulk purchases which involve a lot of funds and can have an impact on the overall portfolio. This makes it very difficult to sell the shares in the market as it can go against the larger interest of the portfolio/investors. It can also impact the share price of the shares in the market.
- If one does not take advantage or monitor the long/short position regularly, a fund may land up suffering huge losses which also involves high rate of fees.
- The portfolio manager must correctly predict the relative performance of 2 stocks which can be difficult and a sticky situation since the point of decisiveness of the manager is what will matter.
- Another risk which can result from such a technique is a “beta mismatch”. It essentially indicates that when there is a sharp decline in the overall stock market, the long positions can lose more than the short positions and vice-versa.
Despite the above drawbacks, there are some critical benefits in using such a technique for hedge fund management:
- Most of the investors focus on selecting winning strategies for long portfolios depending on their market knowledge and risk taking ability. However, long/short strategies with the implementation of selling short, enables the investor to take advantage of a wide array of securities.
- The successful management of a well connected and completely integrated portfolio of long and short positions can help in enhancing fruitful returns even in a difficult market scenario.
Equity Strategies – Fundamentalists vs Opportunists
The role of the hedge fund manager is the most important for the equity strategy to succeed as a part of their portfolio. The decisions and the timings of the decision will decide the yields of the funds. The long/short managers can be divided broadly into 2 philosophical camps: Fundamental Bottom-Up Investors or Opportunistic traders. The difference between the two can be highlighted with the help of the below table:
|Fundamental Investors||Opportunistic Traders|
|Philosophy||The focus is on Bottoms Up valuations policy of the company. The aim will be to understand how the firm can perform exclusively and not in relation to the industry’s performance.||The focus is on short term price movements and the technical factors such as market analysis or past price movements of the firm’s stock.|
|Identify Opportunities||It is based on stocks selling at a discount or historical valuation v/s peers or intrinsic value||It is based on prices relative to peer groups performance or the trend lines. It is largely technical driven with scope for mis-pricings or inefficiencies.|
|Initiate Positions||The position to be held and the size are based on the timing, risk/reward analysis, diversification and relative attractiveness.||The position to be held and the size are based on the timing, risk/reward analysis, diversification and relative attractiveness.|
|Position Management||Managers focus on Buy and Hold strategy of the stock based on Value re-assessment or regular re-balancing of the portfolio component.||Such traders change the size of the position based on technical factors and news associated with the specific company or the industry as a whole.|
|Sell Discipline||They use fundamentals to set expectations for futuristic exit.||They rely more on stock performance or market specific technical factors to determine the exit.|
In general, for fundamental managers, the core skill set and value driver is an ability to determine the attractiveness of industries and companies based on their growth characteristics, sources of income, competitive positioning and financial attributes. They aim to own quality businesses experiencing strong prospects of growth, financial flexibility and operating conditions shall drive the performance of the securities. The idea is to take possession of these assets at attractive valuations and sell them when they reach at the desired targeted level.
In contrast, the traders bank on short term price movements and portray a more defensive approach. They hold the opinion that the swings in market performance occurs often without any definite reason. The holding period could be as short as an hour and normally does not exceed beyond a month. Technical factors, whether associated with the stock market, an industry or the companies are responsible for driving the investment decisions. For e.g. the stock price in the last 3 months or the indication of the Volatility Index will have an impact on the decision making of the opportunistic trader. Resistance and Support levels driven by macro events are additional factors which can drive the decision making process.
In a nutshell, equity long-short strategies may help increase returns in a tough or choppy market scenario, but also involves substantial risks. As a result, the hedge fund investors considering such strategies may want to ensure that their funds/portfolios follow strict rules for market risk evaluation and trace profitable investment opportunities.
Financial advisors are in a position to potentially guide the investors towards a prudent decision making for shifting some of their long only allocation to long/short equity strategies and the potential benefits associated with it.
Historically, long/short equity hedge funds have provided returns that compare favorably with the larger equity market reducing the impact of volatility on the fund a relatively smaller peak – to – trough declines.
However, the challenge of this approach is that it constitutes a large and various categories of funds encompassing many styles, mangers and risk – return characteristics. How the mangers establishes a fair balance while using this strategy is the crux to extract maximum benefit.