The benefits and challenges of a long-short equity strategy

A long-short equity investment strategy can help investors profit from rising and falling markets, even when prices drop sharply. This downside protection could have strong appeal with the advent of Trump-induced financial market volatility in 2025 and falling markets.

Unlike traditional long-only equity funds that typically struggle to gain in bear markets, a well-executed long-short strategy can still deliver positive returns through successful short selling and well-chosen long positions in resilient equities. The objective is to generate alpha, or returns above the benchmark, regardless of the direction of the stock market.

This approach differs from traditional long-only strategies, which rely solely on markets moving higher to generate gains for investors. Here, the goal is to profit when the price of these equities increase. There is a clear downside to this, and we are seeing it this year in markets. Many equities are falling in price.

By looking only for the gainers in a falling equity market, that may leave fund managers with little choice but to join the ride. In a rising market, an investor is only getting half of the investment picture. Most of the investment attention is focused on the winners.

However, by having a focus that looks at the other side of the coin, that is, on those companies that are likely to fall in value, that allows a fund manager to unlock an area of investment that has not been as closely examined as others, and that is where the opportunity lies for the short investor.

This is important for the current times, given we are seeing much greater volatility in global equity markets. The ability to potentially profit in both rising and falling markets could be a significant draw for investors seeking more consistent performance from their equities investments in 2025.

More opportunities for gain

Unlike traditional managed funds, long-short funds do not follow investment benchmarks. Allowing short positions increases the investable universe significantly and reduces index constraints by allowing equity positions to be based on conviction, and not on the market capitalisation of a particular company.

The strategy addresses one of the great limitations for long-only investors in the Australian equity market: the constraint that comes from a very concentrated benchmark. There are several companies at the top end of the Australian market that weigh heavily on the index, namely, the big banks and miners. A long only investor is limited to what stocks they can be long, and also limited by the stocks they can be underweight, because they are limited by the benchmark index.

Having a long-short structure allows a fund manager to short stocks the manager believes are going to underperform the benchmark, and to then reinvest in companies that have better prospects. The strategy provides the opportunity to unlock returns that are not available to long-only investors.

The objective of a long-short strategy is typically to outperform an equity benchmark, slowing for greater leverage to the market when it is rising and less exposure when the equity market is falling. This reduced market exposure can be particularly appealing during periods of heightened uncertainty such as those we are witnessing now under the Trump administration.

Another key advantage of a long-short equity strategy is its potential to dampen overall portfolio volatility as share markets swing. By holding both long and short positions, the strategy can offset market fluctuations. For example, if the broader equity market falls, the losses from the long positions might be partially mitigated by gains from the short positions.

Important considerations on long-short positions

The main risk associated with long-short investing is that it amplifies the investor's exposure to a fund manager's investment skill. If the manager selects stocks poorly, the outcome could be worse than it might be for a long-only equities fund. Experience and track record are therefore highly important for long-equity investing.

There are other challenges. Long-short strategies often use leverage, which means they borrow funds to increase their investment exposure. While this can amplify potential gains, leverage also increases the risk of losses, as investors become more exposed to losing bets.

In addition, short positions have theoretically unlimited downside risk, because the price of a stock can rise indefinitely. Therefore, short positions can have substantially more downside if the value of the stock keeps moving higher.

Long-short equity strategies can also be more susceptible to market liquidity, particularly concerning short positions. It might be more difficult to liquidate short positions quickly and at favourable prices if the market for those stocks becomes illiquid. Furthermore, the size or capacity of the fund can limit its ability to execute short positions effectively, especially if the fund becomes too large.

Understanding and evaluating long-short strategies can also be more complex than traditional long-only investments given the use of short selling. The active trading involved in managing both long and short positions can also lead to higher transaction costs compared to less actively managed strategies.

Fees may be worth it

Investors should be mindful that long-short strategies may come with higher fees compared to traditional long-only equities strategies due to the complexity of managing both long and short positions and the higher level of active management required.

While some long-short funds may charge higher fees compared to traditional managed funds, that can be a small price to pay if an investor's capital is kept intact.

If investors want to enjoy positive returns in a down market and reap downside protection as part of the investment strategy, then the fees charged can deliver real value for money.

Long-short strategies can be paired with traditional long-only strategies to reduce overall portfolio risk and to help boost returns and cushion losses. The potential for consistent alpha capture can offer real value to both longer term investors, or those who are simply seeking protection from wild equity market movements, which may become more frequent under the Trump presidency.