Market Inefficiencies Create Opportunities
Investors often assume that the markets they are invested in always work properly and run smoothly, but the truth is that they don't. Inefficiencies exist in all markets and they can actually present savvy investors with more opportunity and enhanced returns. But they are easier to spot in some markets than others, and in certain markets you may have days to act on an inefficiency, while in others you may have only minutes or seconds. Ultimately, all markets have inefficiencies, some are just harder to identify and act upon than others.
Case Study: Emerging Markets
One example of a market inefficiency is that in many emerging markets, reliable data is scarce and hard to access, meaning sometimes only local investors can use it. Investors who can easily incorporate this data into their analysis may be able to act on an event that isn't apparent to other investors for days or even weeks, giving them an edge.
Case Study: Developed Markets
Another case of market inefficiency takes place in developed markets, which many investors believe to be very efficient. Each day, hundreds of analyst reports about the economy, its sectors and specific companies are published. In any given industry, it could take an investor a week to read all of the reports released in a day, so many reports go unread. However, if an investor builds a computer program to read and consume a report in a matter of seconds, they can act on information that other investors are not aware of yet, putting them ahead of the market.
Long/Short Investing Allows for More Ways to Take Advantage of Market Inefficiencies
Traditional long investing, or buying stocks and holding them for a period of time, is obviously a way to profit when stocks increase in value. But what if you think a stock is going to fall? Short selling, or selling borrowed stock with the intention of buying it back at a lower price later, gives you the ability to profit from this insight also. Bringing together both of these investment techniques to create a long/short strategy allows an investor to generate returns from inefficiencies that cause stock prices to go either up or down.
Market Volatility Can be Mitigated Through a Long/Short Strategy
In addition to giving investors more ways to profit from market inefficiencies, a long/short strategy can help mitigate market volatility. By adjusting the proportion of long and short positions in a portfolio, an investor can control their exposure to the broad market. This makes the portfolio's returns less dependent on market trends and more dependent on the investor’s skill in picking the right stocks to long and short.
The illustration below shows this in action. For instance, if a manager invested all of his money in the stock market (i.e. is 100% long) and then shorts stocks equal to 80% of the portfolio’s value, the result is that the portfolio has 20% net market exposure. The portfolio can then be expected to have 20% of the volatility of the market due to the exposure.