The long and short
of equity investing
FEBRUARY 2013
‘Long’ investing involves buying a share with the expectation
that its price will rise or outperform an underlying benchmark.
Despite evidence of an ongoing economic recovery, global equity
markets continue to suffer from periods of volatility. Longshort strategies provide the opportunity to benefit from rising
and falling markets by sourcing profits from both positive and
negative share price movements. They do this by capitalising on
companies which will either outperform or underperform relative
to others, and by minimising potential loss in falling markets. The
overall aim of a long-short strategy is to deliver positive returns
relative to the portfolio’s benchmark, regardless of
market conditions.
Understanding the long and short of it
A long-short equity strategy simultaneously holds both ‘long’
and ‘short’ positions, and aims to provide investors with strong
returns over the long term and less risk in falling markets.
‘Short’ investing aims to profit from a fall in a stock’s share price.
It involves selling a borrowed share with the expectation that the
share will fall in value, and agreeing to purchase the share back at
a later date. This concept is best illustrated in the example below.
Ways to implement shorting
There are a number of strategies than can be used for shorting.
Some are used for generating higher investment returns while
others aim to reduce the level of risk in a portfolio. Professional
investors will usually use more than one shorting technique at
any one time.
‘Outright shorts’ are used when a stock is expected to fall in value
An outright short is the most commonly used shorting strategy. It
involves selling a stock that is expected to fall in value and buying
it later to profit from the difference in price, as in the earlier
example. Typical candidates for outright shorts are companies
in structurally flawed sectors, companies which may be having
business difficulties, balance sheet issues, are over-priced, or
where there is a risk that the company may not meet its forecast
earnings targets.
An example of a ‘short’ trade
An investment manager has been tracking company ‘XYZ’, and
believes its share price is overvalued. The manager’s research
team has identified the company as having a negative growth
outlook based on eroding margins and lower cost competitors
entering the market.
To act on this belief, the investment manager decides to ‘short’
sell shares in company ‘XYZ’. As the manager does not own any
shares in the company, it ‘borrows’ 1 million shares from a broker
who lends them for a fee.
The manager then sells the shares in the market at a price of $2
per share, receiving $2 million from the trade. After some time,
the share price of company ‘XYZ’ falls, as the manager predicted.
When the shares are trading at $1.50, the manager purchases
1 million of the shares at a total cost of $1.5 million. The
manager then returns the shares to the broker. From this
trade, the investment manager has made a profit of $500,000.
This excludes interest earned, dividends (which are owed to the
lender) and borrowing fees.
$1,500,000
$1,500,000
Borrows 1 million
XYZ shares from
broker
Returns 1 million
XYZ shares to
broker
SELLS
XYZ shares
@$2.00 per share
$1,500,000
$2,000,000
PROFIT
$500,000
$2m
$1,500,000
$1.5m
BUYS
XYZ shares
@$1.50 per share
$1,000,000
$500,000
$0
Day 1
For illustrative purposes only.
Day 2
Day 10
Day 20
Day 30
‘Pairs trading’ is used when two stocks are not following their
usual price behaviour
Sometimes anomalies occur where two similar stocks within the
same industry behave differently from their usual relative price
valuation. Under normal conditions, two stocks may move up and
down at roughly the same pace and have an average valuation/
price difference between them. However, on occasion, the relative
valuation/price difference between the two stocks may diverge
with one stock moving up in price more strongly than the other,
and thus becoming overvalued, only to revert to the average
valuation at a later date. This scenario presents an opportunity
to ‘short’ (or sell) the overvalued stock and ‘long’ (buy) the
undervalued stock.
‘Funding shorts’ use the cash from ‘shorts’ to invest in stocks
that are expected to rise in value
If an investment manager believes the share market will rise
aggressively, there is a likelihood that some stocks in a portfolio
may not keep pace with others. In this scenario, the investment
manager applies what is known as a ‘funding short’. This means
shorting stocks that are expected to underperform in a rising
market, and using the cash from these shorts to invest in stocks
that are expected to rise strongly. It is also possible to ‘short’ a
market index to remove stock specific risk.
Managing risk is an important aspect of shorting
By short selling, the potential amount of loss to the portfolio
may be greater than for portfolios which only buy and hold
investments over the long term. If a short trade goes against
expectations the loss can be unlimited as there is no ceiling on
where the price may rise to. In contrast, a long position can, at
worst, only fall to a zero value.
Investment managers may apply a number of strategies to
mitigate this risk. The most commonly used strategy is to place a
‘stop loss’ (ie. an agreed price to buy the stock) so that if the price
should rise it will limit the losses on the trade. Other types of risk
strategies include protecting positions through the use of option
overlays (writing a protective call) and limiting the size of
‘short’ positions.
How active extension investment
strategies work
As shorting is usually accompanied by ‘long’ strategies, the
industry norm is to specify the level of shorting allowed in a
portfolio in the form of a long-short ratio. A commonly used
investment approach is a 130/30 strategy, although there are
products in the market offering both higher and lower
long-short ratios.
A fund using a 130/30 investment strategy can ‘short’ up to
30% of the portfolio’s net assets. This gives the ‘long’ part of
the portfolio an extra 30% of capital to invest, thus the ‘long’
exposure can be extended up to 130%, totalling a gross market
exposure of 160% (130% long plus 30% short). However, in
real terms, the net exposure to stocks in the portfolio remains
at 100%.
Net stock exposure
100%
-
+
Long
100%
Short
30%
Long
30%
Cash received from shorts is
used to buy more stock
For illustrative purposes only.
Picking the right investment manager
In a ‘long only’ portfolio there is no financial reward for the
investment manager’s negative view on a stock. The best
outcome that can be achieved is a zero weighting for the stock.
With a long-short strategy, an investment manager can profit
from falling prices, so an investor is able to make the best use
of a manager’s stock selection skills.
When picking a long-short investment manager, investors
should, therefore, look for a manager with strong stock selection
abilities, and who uses a robust risk management framework as
part of its investment process. Managers who can display proven
experience of investing through market cycles, and who can
offer an information advantage to their investment process
should be well placed to deliver to expectations for long-short
equity strategies.
Contact us
Financial Planners
AMP Capital’s Investment
Representative on 1300 139 267
Personal Investors
Your Financial Adviser or call
us on 1800 188 013
Wholesale Investors
AMP Capital’s Client Service Team
on 1800 658 404
Important note: While every care has been taken in the preparation of this document,
AMP Capital Investors Limited (ABN 59 001 777 591) (AFSL 232497) makes no
representation or warranty as to the accuracy or completeness of any statement in it
including, without limitation, any forecasts. Past performance is not a reliable indicator
of future performance. This document has been prepared for the purpose of providing
general information, without taking account of any particular investor’s objectives,
financial situation or needs. An investor should, before making any investment decisions,
consider the appropriateness of the information in this document, and seek professional
advice, having regard to the investor’s objectives, financial situation and needs. This
document is solely for the use of the party to whom it is provided.
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