Following the HFR definition, equity hedge investing consists of holding long equities hedged at all times with stocks and/ or stocks index options. The equity hedge strategy is commonly called a “long–short” strategy, being the oldest strategy of the hedge fund industry. Despite this definition, these funds may have a market exposure.
For instance, over the period 1997–2005, hedge funds from the HFR database following an equity hedge strategy had a CAPM beta, computed using the S&P500 as benchmark, equal to 0.52. This demonstrates that equity hedge funds have only a portion of their assets that is hedged.
Some equity hedge funds also use leverage to magnify market exposure. According to Lhabitant (2006), the sources of profit of long–short funds deviate from the traditional investing that is based on capital gains.
There are four sources of gains for an equity hedge fund: the spread between the long and the short position; the interest rebate on the proceeds of the short sale that are used as collateral; the interest paid on the margin deposit to the broker; the spread in dividends between the long and the short position.
The spread between the long and the short position is often obtained by buying undervalued securities and selling overvalued securities. These are stock-picking activities and are related to a selectivity strategy that may be based on the securities’ relative Jensen alphas. Furthermore, equity hedge funds can invest in securities other than equities.