Equity Strategies

Explanation

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 the following 100% Equity strategies or lesser depending on the objective of the fund. The prospectus needs to clearly specify the weight of equity in the basket of a portfolio.

Source: Franklin Templeton

Equity Strategies Considerations

Generally, equities are considered to be the riskier class of assets for investment in comparison to cash and bonds, since the performance of such equities is connected with multiple macroeconomic factors of the economyMacroeconomic Factors Of The EconomyMacroeconomic factors are those that have a broad impact on the national economy, such as population, income, unemployment, investments, savings, and the rate of inflation, and are monitored by highly professional teams governed by the government or other economists.read more 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 flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more 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 impacts the risk to return ratio for a portfolio.

Equity Strategies – Long/Short 

Equity long-short strategies have traditionally been 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 marketBearish MarketBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market.read more scenario thereby, encouraging the investors to consider their portfolio expansion towards possible customized or innovative financial solutions.

source: weitzinvestments.com

An equity long-short strategy is a strategy for investment, used predominantly by hedge funds, which involves holding a long position in stocksA Long Position In StocksLong position denotes buying of a stock, currency or commodity in the hope that the future price will get higher from the present price. The security can be bought in the cash market or in the derivative market. The course of action suggests that the investor or the trader is expecting an upward movement of the stock from is prevailing levels.read more that are expected to increase in value and simultaneous holding of a short positionShort PositionA short position is a practice where the investors sell stocks that they don’t own at the time of selling; the investors do so by borrowing the shares from some other investors to promise that the former will return the stocks to the latter on a later date.read more 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 that is relatively undervalued and sells one which is comparatively overvalued. Ideally, the long position will enhance the value of the stock, and the short position shall lead to a 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 stands 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 (a position held) and again 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 hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market.read more technique depending on the proportion of the stocks held of each company.

Equity long-short strategies such as the above one having equal dollar amounts of long and short positionsLong And Short PositionsThe term “long position” refers to the purchase of securities or commodities with the expectation of making profits. In contrast, when a trader takes a short position, he or she sells securities or commodities with the intention of repurchasing them later at a lower price.read more are called neutral market strategies StrategiesMarket neutral is an investment strategy or portfolio management technique where an investor seeks to negate some form of market risk or volatility by taking long and short positions in various stocks to increase ROI achieved by gaining from increasing and decreasing prices from one or more than one market.read more. For instance, a market-neutral position may involve taking a 50% long position and a 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 the “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., two stocks in the same region or industry is called a “paired trade” model. This may pose a 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:

100060 = $60,000 minus Purchase price of 100050 = $50,000, Gain = $60,000 – $50,000 = $10,000

200025 = $50,000 minus Selling price of 200020 = $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 a 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 the decisiveness of the manager is what will matter.Another risk that can result from such a technique is “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 shortSelling ShortShort Selling is a trading strategy designed to make quick gains by speculating on the falling prices of financial security. It is done by borrowing the security from a broker and selling it in the market and thereafter repurchasing the security once the prices have fallen.read more enable 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 two philosophical camps: Fundamental Bottom-Up Investors or Opportunistic traders. The difference between the two can be highlighted with the help of the below table:

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 that 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 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 often occur 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 three months or the indication of the Volatility IndexThe Volatility IndexVolatility Index, abbreviated as VIX, gives an indication of the expected volatility in the stock market and is based on S&P 500 index options based on 30 days forward period.read more will have an impact on the decision making of the opportunistic trader. Resistance and Support levelsSupport LevelsSupport level (SL) refers to a point in the securities trading below which the price of the security does not fall.read more are driven by macro events are additional factors that can drive the decision-making process.

Conclusion

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 riskMarket RiskMarket risk is the risk that an investor faces due to the decrease in the market value of a financial product that affects the whole market and is not limited to a particular economic commodity. It is often called systematic risk.read more 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 allocations 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 funda 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 managers establish a fair balance while using this strategy is the crux to extract maximum benefit.

  • Multiplier FormulaDebt to Equity Ratio FormulaEquity Multiplier Interpretation