What it means
A traditional fund can only make money when the assets it owns go up. A long/short manager can also profit from falling prices by short selling, which means borrowing shares, selling them now and buying them back later at a lower price.
The gain comes from the difference. Managers use this to reduce market risk.
If the fund is long $100 million of shares it likes and short $60 million of shares it dislikes, a general market fall hurts the first group but helps the second. The result depends mainly on whether the manager's picks beat the market, not on the market's direction.
Two measures describe how a fund is positioned. Gross exposure adds the long and short positions together and shows how much total risk is being taken.
Net exposure subtracts shorts from longs and shows how much the fund will move with the market. Funds vary widely.
Some are close to market neutral, with net exposure near zero, while others keep a long bias with net exposure of 40% to 60%. Some also use borrowing to increase gross exposure, which magnifies both gains and losses.
Costs and risks are not trivial. Shorting involves borrowing fees and potentially unlimited losses if a share rises sharply, and managers typically charge higher fees than for traditional funds.
Investors should check whether the returns genuinely come from stock selection or simply from hidden market exposure. Fees deserve a close look before investing.
Many long/short funds charge a management fee on assets plus a performance fee on profits, and the performance fee is usually subject to a high-water mark (the fund must recover earlier losses before new fees are charged). Investors should compare returns after fees with what a simple, cheaper index fund would have delivered.
In practice
Real-world examples.
Example
A fund buys a well-run supermarket chain and shorts a weaker rival in the same sector. If the whole sector falls but the strong chain falls less, the fund can still make money.
Example
A pension fund allocates $50,000,000 to a long/short manager to diversify away from a portfolio that is already heavily invested in the stock market. The trustees set a limit on net exposure so that the allocation behaves differently from their existing shareholdings, and they review the manager's gross exposure every quarter.
Example
A manager covering the technology industry holds longs in profitable software firms and shorts in companies she believes are overvalued, and keeps net exposure close to 20% during uncertain periods. When she becomes more confident, she raises the net exposure by adding longs and covering some shorts, and she records the reason for each change in her investment diary.
Formula
Calculation
Gross exposure = (Long positions + Short positions) / Fund capital
Net exposure = (Long positions - Short positions) / Fund capital
Suppose a fund has $100,000,000 of capital, $90,000,000 of long positions and $50,000,000 of short positions.
Gross exposure = ($90,000,000 + $50,000,000) / $100,000,000 = 140%.
Net exposure = ($90,000,000 - $50,000,000) / $100,000,000 = 40%.
If the market falls 10% and the long book falls 10% while the short book falls 12%, the longs lose 10% x $90,000,000 = $9,000,000 and the shorts gain 12% x $50,000,000 = $6,000,000. Net result = -$9,000,000 + $6,000,000 = -$3,000,000, or -3% of capital.Case study
Seen in the real world.
Summit Row Capital is an illustrative, fictional long/short fund with $200,000,000 under management. In its first year the manager held 100% gross long and 70% gross short, giving net exposure of 30%.
During a sharp sector sell-off the long book fell 8% and the short book fell 15%. The fund lost 8% x $200,000,000 = $16,000,000 on longs, but gained 15% x $140,000,000 = $21,000,000 on shorts, producing a net gain of $5,000,000, or 2.5%.
In the same fictional story the next year saw a strong rally. The short book rose faster than the long book and the fund lost money, which shows that stock selection is the key driver and that shorts can be painful when markets climb. The manager responded by cutting gross exposure and limiting any single short to a small percentage of capital.
Watch out
Common mistakes.
- Assuming a long/short fund cannot lose money in a falling market, when poor stock picks on either side can produce losses.
- Looking only at net exposure and ignoring gross exposure, which shows how much risk is being run in total.
- Ignoring the fees and borrowing costs, which can consume a large part of the extra return.
Questions
People also ask.
What is the difference between a long/short fund and a market-neutral fund?
A market-neutral fund aims for net exposure near zero, whereas a long/short fund may keep a positive net exposure.
Can a long/short fund lose more than it invests?
Losses on a short position are theoretically unlimited, and leverage can magnify results, so large losses are possible, though funds use limits to contain them.
Who invests in these funds?
Typically institutions and wealthy individuals, although some versions are offered to ordinary investors through regulated fund structures.
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