How do long-short equity strategies work and what are the key performance metrics?

Long-short equity is a hedge fund strategy that takes both long positions (betting on appreciation) and short positions (betting on decline). It aims to generate alpha from stock selection while controlling market exposure.

Basic Mechanics

Starting with $100M capital:

• Go long $120M of undervalued stocks (1.2x leverage)
• Short $80M of overvalued stocks
• Net exposure: $120M - $80M = $40M (40% net long — directional bias)
• Gross exposure: $120M + $80M = $200M (total capital at risk)

Return Decomposition

The portfolio return has three sources:

1. Alpha (long): Return from selecting good longs minus the benchmark
2. Alpha (short): Return from selecting good shorts (profits when they decline)
3. Beta exposure: Net market exposure × market return
4. Rebate income: Interest earned on short sale proceeds (short rebate)

Key Performance Metrics

Example: Meridian Long-Short Fund returns 11% in a year where the market returns 8%:

• Net exposure: 40%, so beta contribution = 40% × 8% = 3.2%
• Alpha = 11% - 3.2% = 7.8% (from stock selection on both sides)
• Short rebate contributed ~0.5%
• Net alpha from stock picking = 7.3%

Short Selling Risks

• Unlimited loss potential: A short position can lose more than 100% (stock can theoretically go to infinity)
• Short squeeze: Heavy short interest can trigger forced covering, driving prices higher
• Borrow cost: Hard-to-borrow securities command premium lending fees (1-10%+ annually)
• Recall risk: The lender can recall shares, forcing position closure at inopportune times

Market Neutral vs. Directional Long-Short

• Market neutral: Net exposure = 0% (equal long and short). Pure alpha strategy.
• Directional long-short: Net exposure = 20-60% long. Alpha + controlled beta exposure.

For the CFA Level III exam, understand how to calculate net and gross exposure, decompose returns into alpha and beta components, and evaluate whether a long-short strategy suits a client's objectives. Practice with our CFA III alternatives materials.