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MARKET INSIGHTS - Long-short Equity Strategy: Effectiveness analysis in both bullish and bearish markets

Long-short equity strategy is one of the oldest and most widespread in the financial scenario.

Long-short equity strategy is one of the oldest and most widespread in the financial scenario. As opposed to a long-only fund whose return is derived more from broad market movement than manager skills, an equity long-short fund relies largely on stock picking capabilities: it consists in the identification of winning stocks, the buy candidates, and losing stocks, the short candidates. In other words, alpha can potentially be generated from both the long and the short sides, differently from traditional long-only funds where alpha is generated from the buy side only.

In the following paper, we will discuss the main characteristics of this strategy, its potential benefits and risks and the related costs and fees. After this qualitative description, we will conduct a more quantitative analysis focusing on different time windows.

First of all, we consider two main different scenarios: long-short equity strategies during downturns, in particular we will consider the Dot-Com Bubble of 2000-2002, the financial crisis of 2007-2008 and the Sovereign Debt Crisis of 2011, and then during bull markets. We analyze the performance in both upward and downward trends and we make some inferences about the main characteristics of these strategies, with respect to the broad market’s returns during the same periods. What we find is a great mitigation of risk during bear markets, but a poor performance during bullish ones.

Finally, we may consider this worldwide pandemic as an opportunity to test the effectiveness of long-short equity portfolios about how they behaved in the past and try to see whether they are still profitable and risk mitigating, as they appeared to be during past downturns: a confirmation of our previous findings is given also during this turbulent period. In conclusion, they behave well during bear markets, but provide poor performance in bullish ones.

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