A long/short fund is an advanced investment vehicle that employs both long and short positions within mutual funds, hedge funds, or exchange-traded funds (ETFs). These funds bet on the price appreciation of chosen investments (long positions) and the price decline of others (short positions). Leveraging techniques like derivatives, short-selling, and more, these funds aim to amplify returns.
Key Takeaways
- Dual Strategy: Long/short funds simultaneously take positions in underappreciated stocks while shorting overpriced ones.
- Beyond the Norm: They move beyond traditional investment strategies by exploiting profit avenues in both undervalued and overvalued securities.
- Popular in Hedge Funds: Typical in hedge funds, these strategies often follow a 130/30 model—130% long exposure and 30% short exposure.
- Higher Costs for Management: Due to the necessity for rigorous active management, analysis, and trading, these funds have higher expense ratios.
Understanding Long/Short Funds
Long/short funds aspire to enhance returns by maneuvering through specific markets using dual positions. These funds demand meticulous active management and expert analysis, which justifies their typically higher expense ratios. As of 2024, these funds averaged an expense ratio of 1.98%, compared to 0.42% across all equity mutual funds in 2023.
While they share similarities with their hedge fund counterparts, long/short mutual funds and ETFs differ notably. They blend higher risk with the potential for significant returns, balanced against standard benchmarks. Unlike hedge funds, they usually offer higher liquidity, do not have lock-in periods, and maintain relatively lower fees—albeit higher than other public funds. Additionally, these funds often have larger minimum investment requirements and may impose front and back-end loads (commissions).
Historically, constraints from the Great Depression era restricted the leverage and risk on mutual funds and ETFs, protecting average investors from overly complex instruments. Despite some regulatory relaxations, stringent oversight persists to safeguard investors from excessive risks.
Long/short funds can be a sound investment choice for those seeking specific index exposure with active management, provided one understands the associated risks. These funds also allow for hedging against market trends, making them adaptable to changing financial landscapes.
The 130-30 Strategy
A prevalent strategy in long/short funds involves taking long positions equivalent to 130% and short positions amounting to 30% of assets under management, aligning a total exposure of 100%. For example, a fund manager might analyze and rank S&P 500 stocks from highest to lowest expected returns.
Using extensive data and quantitative rules, fund managers assess stocks based on total returns, risk-adjusted performance, or relative strength for a specific period. The top-ranked stocks receive 100% investment, while the lower-ranking stocks are short-sold up to 30% of the fund’s value. Proceeds from short sales are reinvested, enhancing exposure to high-performing stocks.
Examples of Long/Short Funds
Here are two distinctive examples showcasing different approaches within this fund category.
QLEIX: AQR Long-Short Equity Fund
The AQR Long-Short Equity Fund is a notable performer globally, spanning multiple sectors. Analyzed data reveals the percentage allocation in both long and short positions across various industries. Annualized total returns over the prior three, five, and ten years stood at 23.04%, 13.32%, and 10.6% respectively until the end of the first quarter of 2024, with an annual expense ratio of 4.35%.
PHDG: Invesco S&P 500 Downside Hedged ETF
The Invesco S&P 500 Downside Hedged ETF, actively managed to pursue positive returns in both rising and declining markets, is another prime example. Unlike QLEIX, this ETF allocates assets within components of the S&P 500 Dynamic VEQTOR Index, encompassing the S&P 500 Index, a volatility hedge (via the S&P 500 VIX Short-Term Futures Index), and cash.
Tracking broader equity markets while hedging against volatility and adjusting exposure based on S&P 500 dynamics, this fund had an expense ratio of 0.39% in April 2024 and yielded returns of 4.41%, 7.05%, and 4.69% over the last three, five, and ten years.
Long vs. Short Investing
Long Investing: Purchasing securities intending to sell them at higher prices later.
Short Investing: Borrowing stock, selling it, then repurchasing it at a lower price to return to the lender, profiting from a decline in stock value.
Similar Investments
Other investments similar to long/short funds include options and derivatives that hedge against equity downside risks. Market-neutral funds take long and short positions in matched stocks to hedge against broad market exposure risks. Pairs trading takes simultaneous long and short positions in related stocks to profits from transient price variances.
Risks of Short Selling
Short selling is riskier due to unlimited potential price increases of securities, unlike long positions where the downside is limited to 100% of the invested amount.
The Bottom Line
Long/short funds capitalize on undervalued stocks while leveraging short sales to maximize returns. However, this strategy brings higher risk, greater costs, and potential liquidity constraints compared to standard mutual funds. Therefore, judicious consideration of the involved risks is crucial for potential investors.
Related Terms: mutual funds, hedge funds, ETFs, short selling, 130/30 strategy, market-neutral funds, pairs trading, risk management
References
- D. Aryeh, T. Alessi, M. Gerber, and C. Kohler. “Equity Long/Short: Because Life Is Too Short To Be Just Long.” Hedge Fund Journal.
- Investment Company Institute. “2023 Fact Book”.
- Financial Industry Regulatory Authority. “Fund Analyzer”.
- B. McCann. “Tactical Portfolios: Strategies and Tactics for Investing in Hedge Funds and Liquid Alternatives”, Pages 3-6. John Wiley & Sons, 2014.
- J. Parnes. “Short Selling for the Long Term: How a Combination of Short and Long Positions Leads to Investing Success”, Pages 82-83. John Wiley & Sons, 2020.
- AQR. “RiverPark Long/Short Opportunity Fund”.
- Gregory-Allen, R.B. et al. “Short Selling by Portfolio Managers: Performance and Risk Effects Across Investment Styles”. In Greg N. Gregoriou, ed., Handbook of Short Selling. Pages 437-451. Academic Press, 2012.
- CMC Markets. “Pairs Trading: An Advanced Strategy for Hedging”.
