One of the fundamental differences between hedge funds and mutual funds is that hedge funds combine long and short positions in their port-folio while mutual funds have very limited capacity to do so and take only long positions. Managers take long positions in a security when they buy this security.
They make money if the corresponding security price increases and lose money if the price falls. In a short position managers make money if the price of the corresponding security falls and lose money if the price of the corresponding security increases. In other words, a short sale is the sale of security not owned.
The idea behind shorting is a simple mechanism:
- a manager first borrows the security through a broker and sells it while the proceeds of the sale go in a margin account;
- when the manager wants to unfold the position, he/she purchases the stock back on the market and returns it to the party from which it was borrowed covering the short position.
The short exposure is measured as the sum of the short positions taken by a manager. The short exposure is subtracted (respectively added) from the long exposure to estimate the net (respectively gross) exposure.