Distinct purposes and exposures require clear selection criteria and governance.
As at 20 October 2023, many institutional allocators are reassessing the role of long only vs long short equity strategies in diversified portfolios. Recent performance comparisons from Australian equity managers show a representative long short fund delivering 21.81% over the prior 12 months, versus 16.84% for a comparable long only strategy and 15.09% for a domestic benchmark, highlighting the potential contribution of active use of shorts. For Sunnov Investment, the question is not which approach is “better”, but how each structure’s exposures, drawdown mitigation tools and implementation costs align with institutional objectives.
Exposure and dispersion
For a conventional long only equity mandate, net and gross exposure are usually identical at close to 100% of capital, since the portfolio owns shares without shorting. Long short strategies separate these concepts. Gross exposure is the sum of long positions and the absolute value of short positions, an indicator of total capital at risk, while net exposure is the difference between the two and therefore a measure of directional market bias. In practice, market‑neutral funds commonly maintain net exposure within roughly minus 10 to plus 10%, low‑net approaches operate around 10 to 30%, and mid or variable‑net strategies more often range between 30 and 60%.
A 130/30 structure illustrates the mechanics. For each unit of capital, around 1.3 is deployed in long positions expected to outperform and 0.3 in short positions expected to lag, generating gross exposure of 160% but net exposure of 100%. Market‑neutral long short managers may use gross exposure in excess of 400% while still targeting negligible net exposure, whereas many mid‑net mandates retain gross exposure below about 150%. When equity dispersion, the spread of returns between the strongest and weakest stocks, is elevated and stock correlations are low, this additional gross exposure can be used to monetise both winners and underperformers, expanding the opportunity set relative to long only portfolios.
The case for long short strengthens when dispersion rises and costs are explicitly budgeted.
Hedging mechanics
Hedging in long short equity relies on the practise of short selling. To initiate a short, the manager borrows shares from a lending broker, sells them in the market, and later aims to repurchase them at a lower price before returning them to the lender. Brokers are generally required to establish “reasonable grounds” that securities can be borrowed. Margin rules typically demand collateral of around 150% of the short position’s value, supported by cash collateral of slightly above the stock value. These mechanics permit investors to express negative views, but they also introduce financing and counterparty considerations that are not present in long only mandates.
When shorts are calibrated to the long book, they can materially assist drawdown mitigation. Historical bear markets have often seen market‑neutral and low‑net long short funds experience smaller peak‑to‑trough declines than broad indices, as gains on the short side partially offset losses on long holdings. Over the trailing decade, an illustrative long short fund delivered about 10.42% annualised, compared with 10.24% for a comparable long only strategy and 8.65% for a domestic benchmark, while in some samples over the same period long short Sharpe ratios have approached 1.0, higher than the roughly 0.56 observed for certain long‑biased hedged strategies. The comparison underscores that the additional tools in long short equity, rather than guaranteeing higher returns, chiefly enhance flexibility in controlling beta, volatility and downside risk.
Liquidity and costs
Long only equity portfolios mainly face explicit trading commissions and market impact, whereas long short portfolios layer on borrowing and financing costs that can materially affect net returns. Borrow fees for hard‑to‑borrow shares, particularly among smaller companies or heavily shorted names, can exceed 10% per year and in extreme squeeze conditions may rise further. Short sellers also compensate lenders for any dividends paid during the holding period. In earlier low‑rate environments the interest earned on cash collateral, or short rebate, often did little to offset these charges, whereas in the recent higher‑rate regime rebate income in some markets now exceeds dividend yields, partially reducing the cost of maintaining shorts.
Liquidity interacts closely with these costs. Shorting smaller or less liquid stocks involves limited free float and modest average daily volumes, which widen bid‑ask spreads and lengthen exit horizons, especially under stress. Sophisticated long short managers therefore diversify borrowing across multiple prime brokers, monitor borrow availability and pricing daily, and embed realistic assumptions about turnover and trading capacity into portfolio construction. By comparison, long only strategies avoid collateral management and recall risk, although they remain subject to liquidity constraints when investing in smaller companies. For allocators, an explicit budget for financing costs and liquidity risk is a prerequisite before increasing gross exposure or allocating to more complex long short implementations.
Suitability by objective
Strategic objectives provide the primary lens through which to assess the long only vs long short choice. Institutions with very long liability profiles, such as endowments, sovereign investors and pension schemes, often favour long only equity as a transparent and operationally simple core holding. Research on institutional portfolios suggests that annual turnover of around 25%, equivalent to a four‑year average holding period, has historically supported stronger compounded outcomes, yet actual turnover across many mandates averages closer to 58%. A growing share of assets is directed towards lower‑turnover strategies, with sustainable and responsible investment funds typically at the lower end of the turnover range, reflecting alignment between longer holding periods and stewardship priorities.
Long short strategies tend to appeal to investors seeking diversification or enhanced risk‑adjusted returns relative to traditional equity or fixed income. Market‑neutral and low‑net funds are usually placed within liquid alternatives allocations, where the objective is to deliver equity‑like returns with limited beta and low correlation to core assets. Directional long short approaches, including 130/30 structures or mid‑net funds with net exposure between roughly 30 and 60%, are more commonly used as partial substitutes for long only equity, aiming to preserve much of the equity risk premium while moderating volatility. In each case, the mandate should specify expected net and gross exposure ranges, leverage limits and permissible use of short selling, so that investors can judge whether outcomes remain consistent with stated objectives.
What to watch
Oversight requirements increase as portfolios move from long only to long short. Long short equity funds often display relatively high correlation to broad indices, around 0.72 in representative long‑run samples, but with much lower beta, in one example near 0.37. In simple terms, a 10% move in the equity market might translate into a gain or loss of only about 3.7% for such a fund. This profile underlines their role as complements rather than full replacements for long only allocations, participating in equity market direction while tempering sensitivity to large market swings.
Investment committees may therefore wish to track a small set of indicators across both structures. Key items include equity dispersion, cross‑sectional volatility and breadth; the evolution of borrow fees and rebate rates; and adherence to agreed limits on gross and net exposure. Rising dispersion combined with relatively stable financing conditions expands the opportunity set for long short managers, provided that assets under management remain within capacity limits. Conversely, narrow leadership, compressed dispersion or elevated borrow costs may reduce the incremental benefit of additional complexity. Clear investment policy statements, evaluation horizons of at least three to five years and explicit governance around performance attribution between the long and short books help align both long only and long short mandates with long‑term institutional objectives.
For long‑horizon allocators, the conclusion is less about favouring one approach unconditionally and more about clarifying roles. Long only equity strategies continue to offer straightforward, low‑cost access to the equity risk premium, with governance that many institutions can manage with existing resources. Long short equity extends the toolkit, providing additional channels for drawdown mitigation and for harnessing equity dispersion, but it also demands tolerance for leverage, financing risk and operational complexity.
As market conditions evolve, many investors expect the relative appeal of long only and long short structures to vary with dispersion, funding costs and regulatory conditions. Periodic reviews of mandate design, capacity and risk budgeting can help ensure that each strategy type continues to serve its intended function within the broader portfolio rather than responding mainly to shorter‑term performance cycles.