Alternative Investments: Hedge Funds

Long-short is the original hedge fund style developed by Alfred Winslow Jones in the 1950s and applied to the stock market. An equity long-short fund aims to profit from rising and declining stocks, whatever the market conditions. The style relies upon traditional stock-picking techniques to identify under and overvalued stocks. It's the technique of shorting to profit from an overvalued stocks that was the radical departure. This allows wider scope for profit-making than traditional stock-picking which limits itself (or is limited by domestic regulators) to earning a return only from stocks which go up.

The proportion of long to short positions held by the fund is called the 'bias'. A fund will have a bias long or short depending on the manager's view of market direction and appetite for risk. A rising market will propel most stocks upwards, so profitable short positions will be harder to find - and vice versa in a falling market.

Most funds typically have a long bias because over the long term, stock markets tend to rise along with general economic growth, so its easier to stock-pick for rising prices.

Let's look at two funds. The first with a long market exposure:

the second a long-short - where the fund has a long bias.

The standard long bias creates a rough hedge against a falling market. If the market starts going down, then the minority short positions will almost certainly pay off. Profit on these will partially offset losses on the long positions - in our example, the long-only fund loses 10 points for a 10 point market fall, whereas the long-short fund only loses 5 points.

But obviously, if the market is in a rising mood and the short stock-picks are driven upwards by bullish sentiment, then the portfolio's profits will be held back by losses on short positions.

A long-short fund is not necessarily going to partially hedged against a falling market. It depends on the bias. A long-short fund could have a very high market risk profile if the manager decides to put on a high proportion of short positions in a rising market. But typically, a long-short fund will tend to offset some market risk by holding more long than shorts in a rising market and more shorts than longs in a falling market - profiting both ways yet keeping some protection built-in against a reversal. Exceptional profit performance ( in rising or falling market ) relies upon accurate long and short stock-picking.