Long/Short Equity Hedge Fund Strategy Paper

Hedge Fund Portfolio Soutions for Advisors

Q1 / 2014 www.crystalfunds.com

H E D G E F U N D S T R AT E G I E S

Long/Short Equity



IntroductionLong/Short Equity Hedge Fund StrategyThe long/short equity strategy is one of the more nimble hedge fund strategies whereby managers seek opportunities across global equity markets with the objective of outperforming tradi-tional markets over a given cycle.

The concept behind the long/short equity strategy is simple: investment research uncovers expected winners and losers and the hedge fund enhances its potential return capabilities by taking a position in both.

Accordingly, one of the major advantages of the long/short eq-uity strategy is that the managers have the flexibility to express their views in opposite directions.

The long/short equity fund manager buys long positions in stocks they believe will increase in value (“the long book”) and shorts positions which they feel will decrease or offer a suitable hedge against certain market or sector risk (“the short book”).

The combined portfolio creates enhanced opportunities for idio-syncratic (i.e. stock-specific) gains and reduces market risk as the short holdings offset the long market exposure.

In all, long/short equity managers largely target equity-like re-turns without the high volatility typically associated with long-only strategies in order to provide a higher compounded rate of return over time.



What are Long/Short Equity Funds? Long/short equity managers are active in equity and equity derivative securities in which they maintain both long and short positions in order to generate returns. The managers aim to de-liver returns in excess of the broad equity markets while seeking to assume less risk in the process.

Unlike traditional long-only equity managers, those that pursue the long/short equity strategy have the ability to use their “short book” to express a negative view on a stock or as a means to hedge market risk in periods of heightened volatility.

As a result, long/short equity funds are generally able to sidestep large drawdowns and compound returns in a more attractive fashion than what is available in the long-only equity world.

The universe of long/short equity hedge funds is quite broad with managers in the space implementing the strategy through a fundamental investment approach or by utilizing quantitative methods to arrive at investment decisions.

In general, managers who employ a fundamental research ap-proach can be specialists in certain sectors (e.g., technology, healthcare, financials, etc.) or sector agnostic and pursue a more diversified approach.

Nonetheless, the objective of the fundamental long/short manager is to uncover opportunities through deep bottoms-up analysis where they aim to identify the intrinsic value of a company.

The fundamental investment approach to long/short equity can also be exercised through a single portfolio manager approach where there is a sole risk-taker responsible for initiating and siz-ing positions or within the context of a multi-manager, multi-strat-egy structure, which has the potential to offer a more diversified return stream.

Alternatively, managers who utilize a quantitative approach to uncovering value in the long/short equity space tend to be broad-er in nature and seek opportunities across all and any sector through the use of both fundamental and technical factors.

Finally, managers within the long/short equity strategy can fur-ther distinguish themselves through the levels of gross and net exposure that they are willing to assume, the average duration of their investment holding period, and the market capitalizations of targeted companies.



The returns of long/short equity managers are determined by the skill of the manager and their ability to successfully navigate the market. By and large, long/short equity managers rely on their stock picking expertise and hedging ability to generate returns.

Success within the space generally hinges on the ability to cor-rectly predict companies that will outperform the market while also discerning the underperformers and shorting them.

The difference between the returns of the long and short hold-ings is referred to as a “spread” and managers who are able to maximize a positive spread offer a more attractive return profile.

The ability of long/short equity managers to deliver a positive spread is largely related to how they utilize their short portfo-lio. A long/short equity manager who mostly employs market hedges in their short portfolio is not taking full advantage of the opportunity to extract double alpha.

For instance, at the most basic level, a manager that estab-lishes a short position in an ETF related to U.S. regional banks to hedge a long holding in the sector is largely focused on at-tempting to reduce sector risks in the name in order to isolate company specific factors as a source of return. Alternatively, a long/short equity manager who views their short portfolio as a

Drivers of Returnssource of alpha would seek out individual names deemed to be overvalued in the sector and subsequently implement a short position with the goal of producing a return that outperforms the index and, thereby, enhances the manager’s spread.

Consequently, the ability to extract alpha on the short side re-quires a particular skillset and is the hallmark of a leading long/short equity manager.

While an overriding factor, stock selection is not the sole driver of long-term returns for long/short equity managers. Managers pursuing the long/short equity strategy have the ability to aug-ment returns by actively managing the levels of gross and net exposure in the portfolio.

Gross exposure is defined as the long portfolio plus the absolute value of the short portfolio whereas net exposure equals the dif-ference between the long portfolio and the short portfolio.

A long/short equity manager who has the foresight to reduce exposure levels before a market correction is able to protect investor capital and offer an attractive means to long term cap-ital appreciation. Conversely, managers who seek to expose themselves to more market directionality would increase their exposures.



The Advantages ofLong/Short Equity FundsBetter Risk-adjusted Returns than Traditional Equity Portfolios Over the past 10 years, long/short equity strategy hedge funds have been able to outperform the S&P 500 with significantly less volatility. As illustrated in the chart below, the CS Equity Long/Short HF Index delivered over 100 basis points of outperformance with a standard deviation of 7.84% versus 14.50% for the S&P 500. This translates into a Sharpe Ratio of 0.78 for the CS Long/Short Equity HF Index compared to 0.41 for the S&P 500.

Annualized ROR

7.67%6.59%

% Months Positive

66.92% 63.85%

Correl to S&P 500

0.81

NA

Sortino

0.37

0.12

Cumulative Value

222.62199.66

Sharpe Ratio

0.78

0.41

Std. Deviation

7.84%

14.50%

Max Drawdown

-21.97%

-52.56%

Jan. 2003 – Oct. 2013Credit Suisse Long/Short Equity HF Index S&P 500 Index

Potential downside protection in major downturnsIt is important to note that long/short equity managers generally run with a low-to-moderate amount of net exposure to equity markets. As a result of operating a hedged portfolio, long/short equity managers typ-ically have not fully participated in runaway bull markets. However, in periods when equity markets faced significant headwinds, the strategy has been able to offer considerable downside protection.

For instance, as demonstrated in the table to the right, the CS Equity Long/Short HF Index has historically outperformed the S&P 500 by an average of 9.54% during the 10 worst quarters for the equity markets as long/short equity funds returned on average -4.37% versus -13.91% for the S&P 500.

This ability to offer protection during equity market downturns has resulted in more attractive risk-adjusted returns and a superior cumula-tive growth for the strategy.

Period S&P 500

CS Equity Long/Short

IndexPerformance

Differential

Q4-2008 -22.55% -7.47% 15.08%

Q3-2002 -17.63% -2.43% 15.20%

Q3-2001 -14.98% -1.84% 13.14%

Q3-2011 -14.33% -9.80% 4.53%

Q2-2002 -13.74% 0.14% 13.87%

Q1-2001 -12.12% -4.87% 7.25%

Q2-2010 -11.86% -5.84% 6.02%

Q1-2009 -11.67% 0.32% 11.99%

Q3-1998 -10.30% -7.80% 2.50%

Q1-2008 -9.93% -4.09% 5.84%

Average -13.91% -4.37% 9.54%



LiquidityLong/short equity managers are recognized for being one of the more liquid hedge fund strategies as they predominantly operate in deep and liquid trading markets. This liquidity generally allows long/short equity managers the ability to quickly adjust exposure levels in order to exploit opportunities or swiftly de-risk the portfolio to sidestep market volatility.

ConclusionLong/short equity managers have been able to use their flexi-bility to deliver returns that exceed those available in long-only equity markets and with significantly less volatility.

The performance of long/short equity funds is driven by manag-er skill and the ability to navigate equity markets as compared to

long-only managers which typically follow the turbulent path of the overall markets.

These long/short hedge funds use their ability to express a negative view on a particular stock, sector or market—along with timely shifts to portfolio exposure levels—to offer enhanced downside protection and the ability to compound returns in a more attractive fashion.

Using CrystalTools© to Evaluate L/S Equity Funds Advisors should consider using CrystalTools© before investing in any strategy or in any individual fund.

CrystalAnalyticsTM – to obtain a better quantitative understanding of the fund’s historical characteristics and individual return profile:

CrystalResearchTM – to gain a better qual-itative assessment of the manager. Learn about their trading strategy, review their li-quidity and provide an overall assessment of the institutionality of a manager.

CrystalPortfoliosTM – to run a simulation of pro-forma returns to better understand the historical performance of a portfolio as well as the effect of adding and removing funds.

Below are a few examples of some of the analytics that CrystalTools© offers.

Monthly Returns - can be used to review the fund’s annualized net returns, risk adjusted returns and individual performance during partic-ular months. For example, advisors can review performance during the worst periods for equity markets and hedge funds, as described above.

Returns Histogram – reviewing the returns histogram will provide the advisor with a better visual understanding of the consistency of the fund’s returns.

Drawdowns – allows the advisor to review the fund’s largest drawdown periods on a twelve

month and thirty six month basis.



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This Document is for informational purposes only and is not an offer to sell or the solicitation of an offer to buy an interest in any of the Funds managed or advised by Crystal Capital Partners, LLC (“Crys-tal”). This document contains only summary information about the Funds and is qualified in its entirety by, and should be read in conjunction with, the more detailed information contained in the Offering Memorandum for each Fund.

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The liquidity schedule constitutes the “best available” liquidity as of the date hereof. The liquidity terms described are for a particular exposure. From time to time, the Fund and/or the Outside Portfolio Manager may offer different liquidity terms. “Best available” liquidity assumes availability when soft lock terms are applicable.

The pro forma results are based on simulated or hypothetical performance results that have certain inherent limitations. Unlike the results shown in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under-or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown.

THE PRO FORMA COMPOSITE PERFORMANCE RECORD IS HYPOTHETICAL AND THESE TRADING ADVISORS HAVE NOT TRADED TOGETHER IN THE MANNER SHOWN IN THE COMPOSITE. HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY MULTI-AD-VISOR MANAGED ACCOUNT OR POOL WILL OR IS LIKELY TO ACHIEVE A COMPOSITE PERFORMANCE RECORD SIMILAR TO THAT SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN A HYPOTHETICAL COMPOSITE PERFORMANCE RECORD AND THE ACTUAL RECORD SUBSEQUENTLY ACHIEVED.

ONE OF THE LIMITATIONS OF A HYPOTHETICAL COMPOSITE PERFORMANCE RECORD IS THAT DECISIONS RELATING TO THE SELECTION OF TRADING ADVISORS AND THE ALLOCA-TION OF ASSETS AMONG THOSE TRADING ADVISORS WERE MADE WITH THE BENEFIT OF HINDSIGHT BASED UPON THE HISTORICAL RATES OF RETURN OF THE SELECTED TRADING ADVISORS. THEREFORE, COMPOSITE PERFORMANCE RECORDS INVARIABLY SHOW POSITIVE RATES OF RETURN. ANOTHER INHERENT LIMITATION ON THESE RESULTS IS THAT THE ALLOCATION DECISIONS REFLECTED IN THE PERFORMANCE RECORD WERE NOT MADE UNDER ACTUAL MARKET CONDITIONS AND, THEREFORE, CANNOT COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FURTHERMORE, THE COMPOSITE PERFORMANCE RECORD MAY BE DISTORTED BECAUSE THE ALLOCATION OF ASSETS CHANGES FROM TIME TO TIME AND THESE ADJUSTMENTS ARE NOT REFLECTED IN THE COMPOSITE.

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Long/Short Equity Hedge Fund Strategy Paper

Economy & Finance

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