A long/short fund holds $120M of tech longs against $60M of index shorts on $100M of capital. The market falls 20% and the fund gains 4%. That only makes sense once you separate alpha from beta, and separating them is the whole point of equity hedge fund analysis.
Every equity hedge fund does three things: picks individual stocks, uses leverage, and takes both long and short positions. What distinguishes one fund from another is net exposure and style tilt, not the toolkit.
Gross and net exposure define the shape of the book. A fund with $80 million long and $30 million short on $100 million capital:
Net exposure = ($80M - $30M) / $100M = 50%
Gross exposure = ($80M + $30M) / $100M = 110%
Net measures directional market sensitivity. Gross measures total risk capital deployed. A 200/150 book has the same 50% net but 350% gross, far more single-name risk. A manager can raise gross without raising net by adding matched long/short pairs.
Common mistakes
- Confusing dollar-neutral with market-neutral. Equal dollars long and short produce zero net dollar but can still carry meaningful beta. Longs averaging beta 1.3 against shorts averaging beta 0.7 leaves 0.6 net beta, failing mean neutrality. Trap: the exam offers "dollar-neutral" as the answer when asking how to eliminate market risk.
- Treating significant alpha as proof of market inefficiency. Joint hypothesis: positive alpha could reflect genuine inefficiency OR a misspecified benchmark model. Trap: "the anomaly proves markets are inefficient." Wrong, name both possibilities.
- Confusing alpha shorts with market-based shorts. Alpha shorts are single-stock or basket shorts with a specific negative thesis. Market-based shorts are index/ETF shorts neutralizing beta. Trap: the exam describes a fund that "shorts a broad index to hedge the book" and asks whether it contributes to alpha. Answer: no, beta hedge, not alpha source.
Bottom line
- Equity hedge funds share three features (stock picking, leverage, long and short positions) and differ mainly in net exposure and style tilt, not toolkit.
- Return decomposes into alpha (selection), beta (net market exposure), and factor tilts (value, momentum, quality, size); alpha is the residual after stripping the other two.
- Funds earn alpha by providing liquidity (capturing the bid-ask spread), supplying informational efficiency, and capturing the complexity premium.
- Anomalies (accruals, price momentum, earnings momentum, net stock issuance, legal insider trading) are always joint hypothesis tests, and alpha decay can erode them within ~3 months.
Exam shortcut
"Alpha short" vs "market-based short", the trigger is a name-specific negative thesis (alpha) versus a beta-hedge purpose (market/index). When dollar-neutral is offered as the answer to "how do you eliminate market risk," it is almost always wrong, beta-neutral requires beta-weighting, not equal dollars; for crisis protection you need variance neutrality, not just mean neutrality.
The full lesson (about 4,463 words, 30 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- distinguishing
- short selling
- returns allocation
- multistrategy
- research
- indices
- macro overview
- macro
- managed futures
- systematic trading
- trend following
- mf dimensions
- systematic construction
- mf benefits
- mf evidence
- mf fund benefits
- event sources
- activist investing
- activism outcomes
- merger arb
- distressed securities
- event multi special
- rv overview
- convertible arb overview
- convertible arb drivers
- vol arb overview
- vol arb strategies
- fi arb
- rv multistrategy
- equity commonalities
- sources of return
- market anomalies
- anomaly strategies
- equity shorts
- three strategies
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