Demystifying Long Short Equity: A Deep Dive into Modern Portfolio Strategy

There are two main reasons to structure and manage a long short equity portfolio:

• Our objective is to generate high absolute returns both during market upswings and downturns, thus capitalizing on opportunities.
• We employ this strategy for to control risk

Our aim is to ensure that no single position can cause severe losses or complete capital erosion.

We strive to attain the right level of diversification where on the one hand reduces portfolio risk but on the other hand allows to achieve substantial returns.

We aim to maximized the portfolio’s risk-adjusted returns (sharpe ratio) regardless of the market direction.

Professional traders achieve a 30-60% return with a 15-30% volatility, with a diversified portfolio of 10-15 positions of correlations between -0.3 and 0.3, a net exposure between -30% and 30% and a Sharpe ratio between 1-1.5.

To general a trade idea we first analyse the fundamentals and then use timing to open a position. A professional trader makes 100-150 trades over a 12–18 month period.

Fundamental Macroeconomic analysis

Professional traders use top-down analysis of global macroeconomic conditions to decide whether portfolio should be long, short or neutral.

Our analysis of leading indicators also guides us in determining which positions to lean towards being Long or Short based on our understanding of the business cycle. ISM Manufacturing, ISM Non-Manufacturing, European sentiment indicator reports are very useful to identify specific countries and sectors to go long or short.

The next stage of the trade idea identification involves identifying WHAT to be long and short based on our portfolio bias (long/short/neutral).

Fundamental Markets analysis

The basic logic on how financial assets behaves during different economic conditions is provided below. There are periods where correlations between financial assets breakdown and where economic data are disconnected from financial markets but the core market logic is described below.

There are two market environments: Risk On periods during which funds flow from safe assets to risky assets and Risk Off periods where funds flow from risky assets to low-risk assets.

Risk Assets (Risk-On): Stocks, Cyclical Commodities, Cyclical Sectors / Industries, High Yield Bonds, Cyclical Currencies, Emerging Markets (Capital flows to emerging markets in search for higher yields, higher growth rates and hence profits)

Safe Assets (Risk-Off): US Treasuries, German Bunds, Defensive Sectors / Industries, US Dollar DXY, Swiss Franc, Japanese Yen, Gold

The most important asset correlation is between the US stocks and US Bonds. During risk on periods US stocks rise while US bonds are sold and vice-versa. Since equities are closely linked with credit, MacroVar monitors closely the performance of corporate bonds for each sector in US and EU markets.

During Risk on Periods the markets behave as follows:

• Global Risk
  • Equity Risk (VIX, VSTOXX): falling
  • Credit Risk (CDX IG, ITRAXX IG, BofA High Yield credit spreads): falling
  • Volatility Term Structure: steep contango
  • MacroVar Risk Index: falling
  • MacroVar Risk On/Off monitor Ratios: falling
• Stocks
  • Global Stocks rising (ideally this should occur with global bond market weakness)
  • US Stock Breadth rising
  • Emerging Market Stocks rising (often outperforming developed markets like US & EU)
  • Global Stock Breadth rising
• Stock Sectors
  • Cyclical sectors outperform Defensive sectors
  • Sector breadth rising
• Bonds (MacroVar monitors 2-year, 5-year and 10-year bonds)
  • Safe Bonds
    • US Treasuries falling (yields rising)
    • German Bunds falling (yields rising)
  • Risky Bonds
    • US High Yield Bonds rising (yields falling)
    • Europe: Club Med Bonds rising (yields falling)
    • Emerging Markets Bonds rising (yields falling)
  • Bond interest rates breadth rising (funds move out of bonds into stocks hence yield rates rise)
• Yield Curve
  • Yield Curve Bear steepening (on the contrary a Yield Curve bull re-steepening signifies Risk Off environment)
  • Fed Funds futures above US 2-year bonds implying strong economic growth and FED hawkish stance
  • Yield Curve Steepening Breadth rising
  • Eurodollar Futures rising
• Currencies
  • US Dollar (DXY) falling
  • Safe Currencies (JPY, CHF) falling
  • Risky Currencies (AUD, NZD, CAD) rising
  • Currencies Breadth (vs the US Dollar) rising
• Commodities
  • Energy (Crude Oil) rising
  • Metals (Copper) rising
  • Safe commodities (Gold) falling
  • Commodities Breadth rising
• Macroeconomic Conditions
  • Global PMI trend and momentum rising
  • Global PMI breadth monitored strong

MacroVar World Markets section is an overview of the major financial markets monitored. Click any of the financial assets to examine the signals of the factors affecting it as well as the asset’s trend, momentum and different statistics monitored.

Sectors

Cyclical Sectors: Cyclical sectors are highly correlated to the business cycle.

Defensive Sectors: Defensive sectors don’t exhibit a strong correlation with changes in the business cycle.

When we anticipate a positive growth trajectory in the Gross Domestic Product (GDP) and expect favorable returns in the stock market, our inclination should be towards holding long positions in Cyclical Sectors while considering short positions in Defensive Sectors.

Conversely, when we predict a negative GDP growth or a notable slowdown in economic activity, our strategy should involve refraining from establishing long positions in Cyclical Sectors. Instead, we should shift our focus towards adopting long positions in Defensive Sectors and short positions in Cyclical Sectors. In instances where we predict GDP growth but anticipate a market correction or downturn, we should prioritize realizing profits and transitioning into a defensive stance for the short to medium term. If necessary, introducing hedging instruments may be considered.

Professional traders’ primary goal is to predict and avoid market corrections and participate in market rallies. Getting market direction wrong for 1 or 2 quarters can adversely affect our returns.

Asset Selection

MacroVar focuses on Stock Indices and Industry sectors (Cyclicals and Defensives). Professional traders looking for outsized returns (but often with higher volatility) select specific stocks in specific sectors from a universe of 2,000+ stocks available.

Selection Processes

A long short portfolio is created by first analyzing macro to forecast GDP growth then selecting the appropriate sectors (Cyclicals vs Defensives) and inside the specific sectors selecting the stocks that tend to outperform the sector. When going long, traders select stocks which lead (appreciate most) the sector, while when short, traders select stocks which lead (decline most) the sector.

If for example, we expect GDP to contract, we short cyclical sectors for example the auto sector and inside the auto sector, Tesla which is the highest valued company in the sector.

Stocks Classification

The industry standard for classifying stocks, is the GICS system (https://msci.com/gics)

Companies undergo both quantitative and qualitative classification processes.

Each company is allocated a singular GICS classification at the Sub-Industry level based on its primary business activity.

The GICS system, utilized by MSCI and S&P Dow Jones Indices, places significant emphasis on Revenues as a pivotal factor in ascertaining the principal business activity of a firm across 11 SECTORS. Of the 74 industries, traders must decide which are cyclical / defensive / or neutral.

Professional traders use GICS to initially select using Top-Down analysis the sectors to get involves in and then using Bottom-Up analysis which stocks to select in their long-short portfolios.

Example: Materials > Chemicals > Fertilizers & Agricultural Chemicals

In this stage, given the portfolio’s macroeconomic bias traders select specific sectors to be long or short. Given sectors selection, traders select which stocks have good fundamentals and can be good potential long stocks and which companies have bad fundamentals and can be good potential short stocks.

Long Short Equity Fundamentals

During economic expansion where GDP is forecasted to grow and stock markets are expected to make gains a trader’s portfolio bias will be going long cyclical growth sectors and stocks and going short ex-growth cyclical and defensive sectors.

Ideal Long trade Setups

To identify long stock trade ideas, proceed with the following filters:

• Select sectors & industries with highest earnings growth %
• Price/Earnings ratio: Ideally long stocks have P/E higher than the average P/E of the sector and at the same time higher PE2 than PE1.
• PEG ratio: Ideally long stocks have PEG2 ratio higher than PEG1
• Positive Earnings growth momentum: Ideally a stock will need to have positive earnings growth above the sector’s earnings growth average and at the same time Faster earnings growth between current year (EG1) and project next year (EG2)
• Positive earnings growth %: Ideally long stocks have top line forward looking % revenue growth expanding
• Market Cap: Mid-cap stocks are preferred to other capitalizations since mid-cap stocks have proven business models and the potential to have strong earnings growth (haven’t reached their peaks)
• Implied Volatility: Stocks with roughly 1.5 times the S&P 500 Implied Volatility (VIX) are considered ideal to provide good trading opportuinities. This can be calculated using annualized historical volatility.

Idea Short trade setups (ref c26 / 27 short waves + turnarounds + value traps ?)

To identify short stock trade ideas, proceed with the following filters:

• Select sectors & industries with lowest earnings growth %
• Price/Earnings ratio: Ideally short stocks have P/E lower than the average P/E of the sector and at the same time lower PE2 than PE1.
• Negative earnings growth momentum: ideally a stock will need to have negative earnings growth below the sector’s earnings growth average and at the same faster negative earnings growth between current year (EG1) and project next year (EG2)
• Negative earnings growth %: Ideally long stocks have top line forward looking % revenue growth contracting.
• Market cap: Large and mega cap stocks ($20bln) are preferred since they have lower volatility than mid-cap stocks, and their business models are mature and vulnerable. Moreover, they have lower level of takeover risk than Mid cap stocks.
• Implied Volatility: Stocks with roughly 1.5 times the S&P 500 Implied Volatility (VIX) are considered ideal to provide good trading opportunities. This can be calculated using annualized historical volatility.
• Short interest: 15-20 Days to cover short interest ratio is dangerous for short squeeze. Register to the website shortsqueeze.com to get stock information. Short interest must be monitored to avoid extreme bearish sentiment, which may mean short stage may be overdone.
• Dividend paying stocks: Shorting a dividend paying stock, makes you owe the dividend back to the stock owner. You should be certain that the dividend will be cut because the business operation is cratering.

Long Short strategies

This is a brief summary of different types of investments strategies used by hedge funds.

• Long Short Value This strategy requires investing in equities the portfolio manager believes are cheap/undervalued by the market. Typically, they look for equities having discounted valuation multiples or generate high free cash flow.
• Long Short Growth This investment strategy focuses on investing in companies based on growth prospects. Fund managers look at companies’ earnings growth and capital appreciation.
• Sector Focused / Niche These strategies focus on investing in specific sectors (healthcare, tech, energy and materials), geographies, or companies of certain market cpaitalization (small, medium, large cap).
• Short Funds These strategies focus on identifying companies that are overvalued based on various investment criteria including expectations, bad management, fraud etc
• Multi Strategy Long Short Equity These funds use a mix of the investment strategies described above.

Long Short Definitions

Spread trade definitions

A spread trade is a trading strategy that involves simultaneously buying and selling two related financial instruments or assets to profit from the spread difference between them. The goal of a spread trade is to take advantage of discrepancies in prices, values, or other relevant factors between the two instruments.

A spread is a trade whereby traders take long positions in Stocks 1 and short position in stock 2.

Spread between stock 1 and 2 is calculated as: Stock 1 – Stock 2

Calculation Percentage Returns

To calculate performance of a long/short position workout percentage returns of each position and apply equal weighting (50%-50%) to long and short sides to deduce overall returns.

Rebalancing

To maintain equal weight to both positions, positions must be rebalanced for a timeframe greater than 1 month or quarter. It is advisable to rebalance on a monthly or quarterly basis to avoid excessing trading costs.

Spread Trade Types

There are two types of spread trades in stocks:

• Cross sector spread trades: Long Health Care (XLU) / Short Consumer Discretionary (XLY)
• Intra Sector spread trades: Long McDonalds / Short Chipotle Mexican Grill
• Cross sector constituent spread trades: Long Chipotle Mexican Grill / Short Philip Morris

Explanation:

After our macro analysis, we forecast future GDP growth expansion. Hence, we look for going long cyclical sectors. One of the cyclical sectors is consumer discretionary. We then look for a stock in the consumer discretionary sector which will outperform the sector. After fundamental analysis of multiple stocks in the sector the trader concluded that Chipotle’s EPS growth will be high. To create the spread trade, the trader goes short a defensive sector. Consumer staples is a defensive sector. After extensive analysis, the trader has concluded Philip Moris EPS growth will fall relative to the EPS growth of the sector. Hence, he believes it will underperform the sector.

Spread Trade selection Process:

• Define Portfolio target risk and correlation between positions allowed
• Forecast GDP using macroeconomic leading indicators
• Analyze which sectors will outperform and underperform the market
• Analyze the stocks which will outperform and underperform the sector and the market
• Structure the portfolio based on the risk you are willing to take: market risk / sector risk / stock risk