Of all the investment strategies currently employed by hedge funds, none provides potential for tremendous gain (or loss) more than shorting. To be accurate, a majority of hedge funds use shorts as part of their overall strategy; however, there are three different types of hedge funds where shorts play a major role: 1) short-only hedge funds; 2) short-bias hedge funds; 3) long-short hedge funds. This article will deal with short-only and short-bias hedge funds in order to understand what shorting can add to a hedge fund's arsenal. It should also be noted that with greater innovation in the financial industry, a wider array of financial instruments has opened up new opportunities for short investors. Whereas short investors traditionally had to place positions through buying stock on margin, hedge funds can now place sophisticated shorts against equities and equities indices through derivatives (e.g. options).
There are a number of strategic advantages for equity short hedge funds. The primary advantage for short hedge funds is the opportunity to drive above average returns with contrarian bets. One of the main tenets underpinning shorting is that the market has mispriced a company's value; hedge funds then can short a stock based on the premise that the market price will decline. Many hedge fund managers drove high returns during the market volatility of 2007-2009 based on prescient shorts against market wisdom: David Einhorn of Greenlight Capital shorted a soon to be bankrupt Lehman Brothers; John Paulson shorted a soon to implode housing sector; numerous hedge funds took large short positions against banks with toxic balance sheets such as Bear Stearns, Wachovia and Citibank. These investors posted above average returns due to their foresight to short in the market and the fortitude to stick with their instincts.
Just like many other investment strategies, the weaknesses of shorting are connected to their strengths. While some investors profited handsomely from shorting the market, others posted significant losses, even to the point of liquidation. A main disadvantage of shorting is that investors can face an unlimited downside if the investment sours: Investors who short typically borrow money to buy a stock, sell it, and then gain profit by buying back the shares at a substantial discount to cover the trade. If the stock price increases between the sell and buy date, however, the fund has to cover the difference. Hedge funds that hedge against short positions somewhat limit their exposure; however, that also in many cases limits the upside.
A second main disadvantage is market architecture; that is, the market can make it difficult to scale up and exit short positions. Hedge funds typically make money through assuming concentrated positions that become profitable through ramping up scale - usually through applying leverage (borrowed money). Short positions, however, are notoriously difficult to acquire adequate scale, particularly if other funds adopt a similar position that can lead to a "crowded trade". Finally, there is significant liquidity risk in taking short positions: During the financial crisis, policymakers viewed shorting as a cause of financial volatility rather than a reaction to it. As a result, numerous governments banned short selling on exchanges. Consequently, many investors found themselves unable to get into new, profitable short positions.
In spite of these notable limitations, hedge funds that feature short positions continue to proliferate in the hedge fund space - largely due to significant turnover among short-only funds that have folded. There will continue to be an active market in shorting, particularly among funds that can spot asymmetries in market pricing.
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FAQs
Shorts: The short portfolio contains stocks deemed overvalued and likely to decline in price. Short positions are taken by borrowing the shares, selling them, and then repurchasing at lower prices in the future to return them. The fund pockets the difference.
What is the equity short strategy? ›
The long-short equity strategy refers to portfolios with a mixture of long and short positions to capitalize and profit from both rises and declines in market prices. Long-short equity funds are designed to profit from the upside potential of certain securities, while mitigating the downside risk.
What is the long-short equity hedge strategy? ›
Long-short equity is an investment strategy that seeks to take a long position in underpriced stocks while selling short overpriced shares. Long-short seeks to augment traditional long-only investing by taking advantage of profit opportunities from securities identified as both under-valued and over-valued.
What is the 130 30 long-short strategy? ›
The 130-30 strategy, often called a long/short equity strategy, refers to an investing methodology used by institutional investors. A 130-30 designation implies using a ratio of 130% of starting capital allocated to long positions and accomplishing this by taking in 30% of the starting capital from shorting stocks.
How do hedge funds make money by shorting shares? ›
To short a stock, a hedge fund will borrow shares of the stock in question (usually from their prime broker) and sell them to other investors who are willing to pay the market price. Then, as the stock price falls, the hedge fund will buy the same shares at a lower cost and pocket the difference.
What are the key differences between a long-short equity hedge fund and a market neutral equity hedge fund? ›
At first glance, equity market neutral funds can look just like long short funds or relative value funds. The major difference is that equity market neutral attempts to keep the total value of their long and short holdings roughly equal, as that helps to lower the overall risk.
What is a good shorting strategy? ›
A good shorting strategy is one that generates returns that are not correlated to the overall stock market. Furthermore, it might also help to mitigate risk and reduce volatility. When stocks are going down, and most investors are losing, you gain if you have some short positions.
What is an example of a long short equity strategy? ›
For example, if a hedge fund has $1 billion in assets under management (AUM), it might put $700 million into long positions and $300 million into short positions. Its gross exposure would be $700 + $300 million = $1 billion, and its net exposure would be $700 – $300 million = $400 million.
Which approach is most commonly used by equity hedge strategies? ›
One of the most commonly used strategies for startup hedge funds is the long/short equity strategy. As the name suggests, the long/short equity strategy involves taking long and short positions in equity and equity derivative securities.
What does it mean to short a hedge fund? ›
Short selling—also known as “shorting,” “selling short” or “going short”—refers to the sale of a security or financial instrument that the seller has borrowed. The short seller believes that the borrowed security's price will decline, enabling it to be bought back at a lower price for a profit.
Long/short funds are designed to maximize the upside of markets, while limiting the downside risk. For example, they may hold undervalued stocks that the fund managers believe will rise in price, while simultaneously shorting overvalued stocks in an attempt to reduce losses.
What is a 30 70 investment strategy? ›
This investment strategy seeks total return through exposure to a diversified portfolio of primarily equity, and to a lesser extent, fixed income asset classes with a target allocation of 30% equities and 70% fixed income.
What is the 200 ma strategy? ›
The 200-day moving average strategy is a long term trend strategy, so it is possible to earn profits at least two or three times the losses. When buying above the 200-day moving average, the rule is to hold the position until prices fall below the 200-day moving average.
How do hedge funds lose money on shorts? ›
A common example of the volatility of short selling is that if the asset price drops on the market the hedge fund will be able to profit on the difference, but if the asset increases in value then it will have to pay the difference, which can lead to severe losses.
How does shorting work for dummies? ›
The method is short selling, which involves borrowing stock you do not own, selling the borrowed stock, and then buying and returning the stock only if or when the price drops. The model may not be intuitive, but it does work. That said, it is not a strategy recommended for first-time or inexperienced investors.
Why do hedge funds short stocks they own? ›
A HEDGE FUND is a securities fund which not only buys stocks for long-term price appreciation but also sells stocks short. The concept of short selling is injected to reduce risk during periods of market decline.
What does it mean to short an equity? ›
A "short" position is generally the sale of a stock you do not own. Investors who sell short believe the price of the stock will decrease in value. If the price drops, you can buy the stock at the lower price and make a profit.
What is equity short interest? ›
Short interest is the number of company shares that are sold short and haven't been closed out. It's represented as a percentage that can be used as an indicator of investor sentiment in the market. You can use short interest to short-sell stocks with the aim to profit if the market price falls.
