Investment Primer: The Long | Short Composite

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Section 1: What, Why, and How of Long/Short Funds

The Long | Short composite includes funds that employ a strategy of both buying (“long”) securities that are expected to increase in value and selling short (“short”) securities that are expected to decrease in value. The “why” is to generate returns in various market conditions, potentially with lower volatility and less correlation to the broader equity market than traditional long-only funds. The goal is to produce “alpha,” or returns driven by manager skill in both picking winners and identifying losers.

The “how” varies significantly. Some funds are actively managed, with a portfolio manager using a proprietary quantitative model to rank stocks for their long and short portfolios. Others are rules-based, tracking an index that systematically takes long and short positions based on predefined factors. These strategies can be applied to broad markets, specific themes, or even pairs of individual stocks.

Section 2: Deconstructing Long/Short Strategies

The specific approach to the long and short “books” is the key differentiator for funds in this composite. Understanding the mechanics of each strategy is essential for aligning the fund with an investor’s goals.

  • Broad Market Long/Short: These funds take long and short positions across a broad market, like U.S. large-cap stocks. They typically use quantitative models to rank stocks based on factors like value, momentum, and quality. The fund will buy the highest-ranked stocks and short the lowest-ranked ones. Often, these funds maintain a net long exposure, meaning the value of the long positions is greater than the short positions. A common variation is the 130/30 strategy, where a fund uses leverage to take a 130% long position and a 30% short position, resulting in a 100% net exposure to the market but with the potential for alpha from the short sales.
  • Market Neutral: The goal of a market-neutral fund is to have a beta of zero, meaning its performance should be independent of the overall market’s direction. This is achieved by creating long and short portfolios that are equal in value and designed to offset each other’s market risk. For example, a fund might go long a portfolio of low-beta stocks and short a portfolio of high-beta stocks, aiming to profit purely from the spread between the two, regardless of whether the market goes up or down.
  • Thematic & Pairs Trading: These are highly targeted strategies. A thematic long/short fund takes a view on a specific trend by going long the expected winners and short the expected losers (e.g., long online retail, short brick-and-mortar stores). A pairs trading fund takes this to an extreme, focusing on the relative performance of just two specific stocks (e.g., long Tesla, short Ford).
  • Tactical Long/Flat: A variation on the long/short theme, these funds do not take explicit short positions in stocks. Instead, they tactically rotate their portfolio between being 100% long the market and being 100% in a defensive “flat” position, such as cash or Treasury bills, based on a proprietary model or market signal.

Section 3: A Practical Guide to Locating Funds in the ETF Action Database

ETF Action’s classification system allows users to efficiently find the specific type of long/short strategy they are looking for.

3.1 Foundational Screening: Building the Initial Universe

  • Step 1: Select the Database. Navigate to the ETF, Mutual Fund, or other desired database.
  • Step 2: Filter by Asset Class. Select Asset Class = Non-Traditional.
  • Step 3: Filter by Sub-Asset Class. Select Long | Short.
  • Step 4: Filter by Composite. This is a key filter that identifies the underlying market for the strategy (e.g., EQ: Size & Style – U.S., EQ: Thematic, EQ: Single Stock).

3.2 Advanced Filtering: Refining Your Peer Group

  • Brand (Issuer), AUM, Expense Ratio, Liquidity: Use these standard filters to narrow the list to viable candidates.

Section 4: A Framework for Evaluating Long/Short Funds

Evaluating a long/short fund requires focusing on its ability to generate alpha and manage risk, which goes beyond a simple total return analysis.

4.1 Risk/Return Analysis: The Importance of Benchmarks

The foundational step is to analyze a fund’s historical risk and return profile against a broad market benchmark. ETF Action assigns a Beta Tracker to each category (e.g., ACWI for global funds) to provide a relevant peer for comparison.

  • Total Return: How has the fund performed over various time periods?
  • Standard Deviation (Volatility): A key metric. A successful long/short fund should exhibit lower volatility than its long-only benchmark.
  • Sharpe Ratio: Did the fund provide better risk-adjusted returns? A higher Sharpe Ratio than the benchmark is a primary goal.
  • Beta: This is a critical measure of the fund’s sensitivity to the overall market. A market-neutral fund should have a beta close to zero, while a net-long fund will have a positive beta, but it should be lower than 1.0.
  • Alpha: This is the ultimate measure of success. Did the fund generate returns that were not explained by its market risk (beta)? A consistently positive alpha indicates manager skill.

4.2 Quantitative Analysis: The Power of Look-Through Analytics

A fund’s name tells you its strategy, but its holdings reveal how it’s actually being implemented.

  • Net & Gross Exposure: What is the fund’s typical net exposure (long positions minus short positions)? This determines its overall market directionality. What is its gross exposure (long positions plus short positions)? This indicates the total amount of capital at work.
  • Long & Short Book Analysis: Look-through analysis should be applied to both the long and short portfolios separately. What are the sector, style, and factor characteristics of the stocks the fund is buying versus the ones it is shorting? This analysis reveals the specific bets the manager is making and is the key to understanding the sources of alpha.
  • For Thematic & Pairs Funds: The analysis must focus on the specific holdings to confirm that the fund is truly expressing the stated theme or pairs trade.

4.3 Qualitative Analysis: Evaluating the Strategy

  • For Active Funds: The manager’s process is everything. What is their investment philosophy? What does their quantitative model look for when identifying long and short candidates? Is the process repeatable and consistent?
  • For Passive/Rules-Based Funds: The key is to understand the index methodology. What are the specific, rules-based criteria for including a stock in the long or short portfolio? How often is the index rebalanced?

Section 5: Leveraging ETF Action’s Reporting Suite for Deeper Insights

The ETF Action platform provides reports to help investors analyze these complex strategies.

5.1 A Guide to Composite-Specific Reports

The Non-Traditional: Long | Short categories have a specific set of available reports.

  • League Table & Landscape (AUM & Flows): Useful for identifying the largest and most established funds.
  • Risk & Return: This is the primary quantitative report for this composite. It provides the key metrics needed for evaluation, including historical returns, standard deviation, beta, and alpha.
  • Equity Exposure & Equity Fundamentals: These reports are essential for conducting the look-through analysis on the fund’s long portfolio.
  • Ownership Trends (1f): Shows which institutional investors are using these products.

5.2 A Practical Workflow: Synthesizing Reports for a Holistic View

  1. Screening & Peer Group Creation (Section 3): Use the database filters to find a fund with the desired underlying market and strategy.
  2. Initial Triage (League Table & Landscape): Narrow the list to viable candidates based on AUM, flows, and fees.
  3. Quantitative Deep Dive (Risk & Return): For shortlisted funds, use the Risk & Return report to conduct a thorough analysis of the fund’s performance against its Beta Tracker, with a specific focus on its beta and alpha.
  4. Look-Through Analysis (Equity Exposure): Use the equity reports to analyze the characteristics of the fund’s long portfolio to understand its positioning.
  5. Final Due diligence (External Research): Armed with this data, proceed to the final and most critical step: reading the prospectus to fully understand the fund’s specific long/short methodology, its target net exposure, and its risks.