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Long short equity is an investment strategy used primarily by hedge fund managers, who are money managers who make trading decisions in a portfolio. It is a common strategy among this group, and it is driven by betting on a stock's direction. The long part of the equation is a bet that a stock investment will rise in value. The short end represents a wager that a stock's value will decline. When executed effectively, a long short equity strategy will minimize a trader's risk exposure to the financial markets.
The very first trading strategy to be used by a hedge fund manager was long short equity. In 1949, Alfred Winslow Jones decided there must be a way to make money even when the financial markets were declining. This is how shorting equity came about. When a trader goes short equities, he protects or hedges market risk by going long equities in a separate trade. It is among the most straightforward and widely subscribed to out of dozens of hedge fund strategies.
Profits in a long short equity strategy are generated by the difference or spread between the trading positions. Ideally, a hedge fund trader will take a long position in stocks that are undervalued based on an expectation that the securities will rise in price. On the other side of the trade, he will short equities that he considers overvalued, and that are likely to decline. If the fund manager plays the markets correctly, he will reap profits on the trades.
While the fundamentals of a long short equity strategy are constant, it does have different applications. For instance, a hedge fund manager who trades using long short equity might have a long or short bias, meaning he trades a larger percentage of a portfolio in either direction. Also, a long short equity manager may be set apart by the regions in which he trades and the sectors that he invests in.
Since so many hedge fund managers use long short equity as part of a trading strategy, there is a risk of following a herd mentality in the industry, which increases market risk. If the majority of fund managers are long equities in a particular sector, such as energy, and short equities in another industry, say financial stocks, managers are placing similar trades and betting a large percentage of the total hedge fund industry's assets. The equity markets can be unpredictable even for the most sophisticated of traders. If one or both of those trades implodes or does not play out as intended, a large portion of industry assets can be lost.