49 Long/Short Investing Strategy

When investing, broad diversification can reduce your risk.  Many investors limit themselves to bond funds and stock funds.  In many 401k, and other employer sponsored plans, bond and stock funds are the only option.

The stock market is at all time highs and with this current administration there is  much uncertainty.  Bonds currently offer very low interest rates.

In addition, interest rates moving up which causes the value of bond funds to go down.  The losses of the bond fund value is proportional to the duration of the underlying bonds held in the bond fund.  The longer the duration, the more the loss.

The only way to achieve higher bond returns with the same duration is by investing in lower quality bonds, which pay higher interest but have risk.

Real estate, commodities, preferred stock, liquid and illiquid alternatives are all investments that provide diversification from stocks and bonds.  These investments are not correlated 100% with the stock or bond markets.  You can read more about alternative investments in our blog: 39 Alternative Investments.

Since the 2009 stock market downturn, we have had many clients interested in alternatives to the stock and bond markets.  Structured Products (discussed in episode #21) are one option to protect market investments from loss.

Another option is long/short funds.  Buying long is a traditional purchase investment in a holding (such as a stock). An investor makes money when the value of the stock moves up and loses money when the value moves down.

A short, or short position, is a directional trading or investment strategy where the investor sells shares of borrowed stock.  If the price of the stock decreases, the investor will purchase the shares and return the shares to the broker which he borrowed them from.  In a short position, the investor makes money when the value of the stock moves down and loses money when the value moves up.

The short positions hedge the long investments from losses. One advantage of the long/short structure is that the manager does not need to commit to volatile stocks if conditions are uncertain.  Long/short funds have a potential to benefit from markets going up or down.  This control can make it easier to avoid really large mistakes.

Historically, adding long/short exposure to a portfolio improves the risk-adjusted returns.

There are four basic long/short strategies:

  • Fundamental long/short – bottom up equity analysis
  • Sector or Thematic long/short – focuses on a specific sector or industry theme
  • Macro long/short – economic and systemic influences are the drivers
  • Comprehensive long/short – manager blends both top-down and bottom-up considerations

The goals of using a long/short strategy are to beat market indices during down markets and deliver equity competitive returns over a full market cycle.

The table below show the

The Sharpe Ratio is a measure for calculating risk-adjusted return, and this ratio has become the industry standard for such calculations.

NameS&P 500Barclay Aggregate Bond IndexEquity Long/Short Index
Sharpe Ratio 3yr1.00.60.9
Sharpe Ratio 5yr1.30.41.2
Sharpe Ratio 10yr0.50.80.7
Sharpe Ratio 15yr0.50.70.8
Return 15yr7.64.25.9
Return 20yr7.65.08.1

I appreciate any feedback for our AIO Financial blog. Please contact me if you have any comments, questions, and suggestions. You can comment here or contact me through Facebook, Twitter, email (bill@aiofinancial.com), or call 520-325-0769. Click here to schedule a free meeting with Bill Holliday, CFP.

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