Long/Short Equity Explained, With a Worked Example

A long/short equity fund buys stocks it expects to do well and sells short stocks it expects to do badly. Selling short means selling borrowed shares, with the aim of buying them back at a lower price.

In our worked example, a fund loses 6.0% when the market falls 10% and its picks only match the market. With right picks it gains 4.0%. This guide shows the arithmetic, the cost of the short side and what the public record shows.

The long book is the stocks the fund owns, which gain when prices rise. The short book is the stocks it has sold short, which gain when prices fall.

The SEC describes a short sale as generally the sale of a stock the seller does not own, or one the seller will borrow for delivery. If the price falls, the short seller buys it back at the lower price and profits. If it rises, the short seller loses money.

The SEC lists several uses for short selling, including profiting from an expected fall and hedging the risk of a long position in the same or a related security.

A 2003 SEC staff report credits Alfred Winslow Jones with establishing one of the first hedge funds in 1949. It used short selling to "hedge" its exposure to movements of the equity market.

We explain hedge funds in general in What Is a Hedge Fund?

Exposure is the value of stocks held, as a share of the fund's capital. Gross exposure adds the long book and the short book. Net exposure subtracts the short book from the long book.

Our example fund has $100 million of capital, $130 million in its long book and $70 million in its short book. That is a gross exposure of 200% and a net exposure of 60%.

The chart shows each figure as a share of capital. Net exposure sets how much the fund moves with the market if all its stocks move with it. A 10% market move changes the example fund by 6.0%.

How far one stock moves with the market is called beta, which we explain in What Is Stock Beta?

The example uses three stock-picking outcomes. With flat picks, every stock moves exactly with the market.

With right picks, the stocks the fund owns beat the market by 5 percentage points and the stocks it shorted trail it by 5 points. Wrong picks reverse that.

When the market falls 10%, the three outcomes are:

The chart adds a market that rises 10%. Flat picks gain 6.0%, right picks gain 16.0% and wrong picks lose 4.0%. In the wrong-picks case the short book loses $10.5 million, more than the $6.5 million the long book gains.

Right picks are worth 10 points of capital here, which is 5% of $130 million plus 5% of $70 million. At that size the fund would break even if the market fell 16.7%. The figures are chosen to show the mechanics, not a typical record.

The SEC says the lender charges interest on the borrowed shares. If the stock pays a dividend, the short seller must pay the dividend to the lender.

D'Avolio (2002, Journal of Financial Economics) studied 18 months of loan data from April 2000 to September 2001, from one large institutional lending intermediary. The value-weighted cost to borrow was 25 basis points a year, or 0.25%. A basis point is one hundredth of a percentage point.

Of the stocks lent out, 91% cost less than 1% a year to borrow. The other 9%, which the paper calls "specials", had a mean fee of 4.3%. These figures describe 2000 to 2001, so today's fees may differ.

At 0.25% a year, borrowing $70 million of shares would cost $0.175 million, or 0.175% of the example fund's capital. A $7 million short position, a tenth of the short book, at 4.3% would cost $0.301 million a year.

Losses on a short position are not capped. The SEC notes that shorting leaves an investor open to the possibility of unlimited losses, since a stock can theoretically keep rising indefinitely. A $7 million short in a stock that doubles loses $7 million, or 7% of the example fund's capital.

The example leaves out fees, trading costs and interest on cash. We cover the fees in our hedge fund fees guide.

Form 13F is the filing made by institutional investment managers that exercise investment discretion over $100 million or more in Section 13(f) securities. The SEC's staff answer on short positions is "You should not include short positions on Form 13F".

So a 13F lists a manager's long positions and cannot show how much of them a short book offsets. Figures on gross and net assets come from a different filing, Form PF.

Form PF is the filing that SEC-registered private fund advisers with at least $150 million in private fund assets generally must make.

The Office of Financial Research (OFR) publishes Form PF data for qualifying hedge funds. These are funds with at least $500 million of net assets, advised by a firm with at least $1.5 billion in hedge fund assets.

Gross assets are everything a fund holds. Net assets are what is left after what it owes. A multiple of 1.84 means the funds held $1.84 of assets for every $1 of investors' money, with the rest funded by borrowing and other liabilities.

The chart plots that multiple for equity-strategy funds, with each fund's ratio weighted by its net assets. It was 1.55 in March 2013, 1.43 in September 2021 and 1.84 in June 2026.

Gross assets are not the same as the gross exposure in our example, so these figures cannot be set against the 200%.

A long/short fund's result comes from its net exposure, its stock picking on each side and the cost of the short book. Whether such funds beat the market is a separate question, which we answer in Do Hedge Funds Beat the Market? The Public Record

This explainer is part of the YX Insights Academy. Each one takes a single idea and checks it against real data.

The same approach runs through everything else we publish:

Good places to start on the website:

It is a hedge fund strategy that holds a long book of stocks it owns and a short book of stocks it has sold short. The long book gains when its stocks rise and the short book gains when its stocks fall. The fund's return depends on the market and on how well it picks stocks on each side.

Gross exposure adds the long book and the short book, while net exposure subtracts the short book from the long book. In our example a $100 million fund holds $130 million long and $70 million short, so gross exposure is 200% and net exposure is 60%.

Yes. In our example with wrong picks, owned stocks trail the market by 5 points and shorted stocks beat it by 5. A 10% market rise then leaves the fund down 4.0%, because the short book loses $10.5 million and the long book gains only $6.5 million.

Not on Form 13F. The SEC's staff answer is that short positions should not be included. Institutional investment managers with investment discretion over $100 million or more in Section 13(f) securities file the form, so it shows only the long side of a long/short fund.

DISCLAIMER: This article is strictly educational. Any information or analysis in this note is not an offer to sell or the solicitation of an offer to buy any securities. Nothing in this note is intended to be investment advice and nor should it be relied upon to make investment decisions. Any opinions, analyses, or probabilities expressed in this note are those of the author as of the note's date of publication and are subject to change without notice.