Long Only vs. Long / Short

This week I discuss the difference between long only and long/short investment strategies. The biggest difference is the involvement of shorting stocks (duh), where a fund borrows stocks, sells them at what the fund believes to be overvalued price, expecting them to decline and then buys the stocks back at a lower price. 

At first glance, the mechanics of shorting is the mirror image of buying (or long) a stock. In reality, shorting is not just directionally opposite because of its infinite loss potential (a long position has 100% loss potential), liquidity and market flow consideration. All of these characteristics manifested themselves during the r/WallStreetBets fiasco. Therefore, shorting warrants its own discussion in a future article, but it's worth mentioning these issues which make long/short a very different beast compared to long only. 

Long only (“LO”)

Long only (“LO”) funds spend 100% of their effort on identifying undervalued stocks, buying them, and selling them when the rest of market realizes the fund is right and the stock goes up. When overall market is expensive, LO funds have the discretion to stay in cash (evident in Berkshire Hathaway building a giant cash pile).

Most mutual fund companies and a small number of hedge funds offer long only products (though mutual fund companies start to offer long/short products as well). Typically, the LOs have longer-term investment horizon with stable investor base and significant scale, which translate to relatively better lifestyle and career stability.

Examples of LO investment firms:

  • Boston is the headquarter for many mega-LOs: Fidelity, Wellington, Putnam, MFS, Eaton Vance, Columbia Threadneedle, etc.
  • California: Capital Group, Franklin Templeton, Dodge and Cox
  • Baltimore: T. Rowe Price
  • New York: Bernstein, Clearbridge, First Eagle
  • Midwest: Harris Associates, Artisan Partners

Long short (L/S)

A long/short fund effectively has two portfolios running at the same time:

  • a long “book”, which is a portfolio of stocks similar to a LO in that the fund is buying low and selling high.
  • a short “book”, where the fund is borrowing stocks, selling them at an overvalued price expecting them to decline, and then buying them back (known as “closing the short”) at a lower price to generate return.
Majority of hedge funds are long/short funds.

    To understand long/short funds, you need to be familiar with two terms: gross exposure and net exposure.

    • Gross exposure: A hedge fund’s long positions + short positions, expressed in dollar or percentage terms.
      • If a hedge fund has $500 million in capital, and it deploys $250 million in long positions and $250 million in short positions, the gross exposure is $500 million. On percentage basis, 50% exposure in long, 50% exposure in short, and gross exposure is 100%.
      • If the gross exposure exceeds $500 million or 100%, the hedge fund is using leverage, meaning it is borrowing money to amplify returns (but increasing risk.). Conversely, if gross exposure is below 100%, a portion of the portfolio is sitting in cash.
      • Gross exposure measures a fund’s total exposure to financial markets, giving investors insights into amount of risk taken.
    • Net exposure: Calculated as the difference between a hedge fund’s long positions and short positions. For the aforementioned hedge fund with $250 million in long positions and $250 million in short positions, its net exposure is zero (which is market neutral, a style that I will explain to you below). A hedge fund can adjust net exposure up (to be net long) or down (to be net short). A net long fund will do better in an overall up market and net short fund will do better in an overall down market.

    Within the long/short world, there are two types: market neutral and directional.

    “MM” / “Pod Shop” - Market Neutral L/S

    A market neutral fund, if constructed properly, has zero correlation with the daily overall market movement. For example, if a portfolio manager (“PM”) runs a portfolio that is neutral to S&P 500 index, the PM can take a 50% long position in some S&P 500 stocks that they believe to be winners, and take a 50% short position in ones believed to be losers. Hypothetically, if the S&P 500 is down 5% on a trading day and there is no company-specific news on the stocks in the fund, the long positions will have a 5% unrealized loss and the short positions will have 5% unrealized gain, thus the overall portfolio has no gain or loss on that day, neutral against S&P 500 movement that day. 

    The return generated by a market neutral fund should then be completely dependent on company-specific events (such as companies exceeding or missing quarterly consensus) for stocks within the portfolio.

    Over the years, market neutral strategy has enjoyed tremendous amount of success because they deliver uncorrelated outperformance to their investors.

    Perhaps you have never heard of the term “market neutral funds,” but many of you must have heard of the term “multi-manager (MM)” or “pod shops.” Before I explain what they are, let me introduce the firm names and their billionaire founders who frequently engage in pissing contests to see who can buy the next Manhattan / Miami penthouse or Greenwich / Hampton mansion. They are:

    • Citadel: Ken Griffin
    • Millennium Management: Izzy Englander
    • Point72 (previously SAC Capital): Steve Cohen

    Why are these shops called multi-managers (MM) or pod shops? It’s because these firms are not run by a single portfolio manager. The MM provides a platform for hundreds of portfolio managers to run their portfolios autonomously. And each portfolio is a “pod”.

    For example, when a PM joins Millennium Management, they contractually agree to some sort of risk limits (eg. that their portfolio will not have a more than x% decline over a defined period). If the PM breaches the risk limit, the PM and junior analysts supporting the PM are dismissed from the firm. It’s not personal, just how the system is designed and contractual agreement. 

    You might wonder: Why does a pod shop impose risk limits on each PM? The reason: Pod shop / multi-manager platforms employ leverage. For an individual PM with (already levered) allocated capital, losing 3% on the portfolio level magnifies loss (ie. multiple of 3%) on the platform level. In such model, risk control is paramount.

    As you can see, if you are not a believer of constantly worrying about every stock movement, especially if the movement is not driven by change in fundamental thesis, MM investing is very stressful. In return, MM investors are compensated handsomely and the PM truly eats what they kill instead of being at the mercy of the generosity of a single-manager hedge fund founder (discussed in the next section).

    You just need to know that under the hood, MM investing provides the lowest relative quality of life and no career stability on the buy-side, in exchange for the most attractive financial reward and fastest path for becoming a PM if an analyst is successful under this model.

    Directional Single Manager L/S

    Most of single manager hedge funds are directional long/short funds, which means one person – the Chief Investment Officer or the PM – is responsible for sizing positions and deciding what to buy or sell on the long side and what to short or "close short" (ie. buying it back at a lower price.) on the short side.

    The biggest distinction versus the multi-manager / pod shop is the ability to decide how the portfolio should be exposed to the overall market movement. If the PM believes overall market is going up, they can increase the net exposure. Conversely, if the portfolio manager overall market is going down, the PM can reduce net exposure.

    Examples of single manager directional L/S hedge funds:

    • Tiger Cubs are mostly single-manager long/short: Tiger Global, Lone Pine, Coatue, Maverick
    • D1 Capital (founded by Daniel Sundheim, ex-Viking Global CIO)
    • Appaloosa Capital (founded by David Tepper)

    What strategy should I work under?

    No right answer, but I strongly suggest you introspect rigorously on the aspects of a job that matter to you. I completely understand that it’s hard enough to just land an interview in this profession, but picking a paradigm that suits you ensures longevity in this profession. The decision comes down to the tradeoff amongst: lifestyle, stability, compensation and speed to risk taking role (time it takes to become a PM). 

    If you are interested in learning more about professional equity investing (the "buy-side"), I have two other great articles for you:

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