[MUSIC] Hi there. So in this video we're going to see how long position can be combined with short position. You know this short selling we just saw. We'll see how it can be combined so that we make a long short equity fund. So the learning outcomes is that you'll be able to understand the main difference that there are between being long, being short, to also get a sense of the various characteristics that there are for hedge funds in terms of returns and risks. And also how these hedge funds managers may outperform the market. And I'm going to illustrate this with a practical example. If you go into some finance book, they tell you about the best example for diversifying your assets is not put the same eggs in the same basket, and they give you one illustration of doing so is umbrellas and ice creams. Umbrellas and ice creams? [LAUGH] What are we talking about here? Well, the idea is quite simple, and actually I saw that. I live in Geneva, and some years ago I was taking a train from nearby, Lausanne to Geneva. And one day, just under the station, I saw a guy selling umbrellas. The weather was miserable and he was selling quite a few of them. And he was standing next to this machine that were making these ice cream next to a big store. So I said, aha, maybe the next day. And I walked to him and I say, hey, maybe next day instead of selling umbrellas, if the weather is sunny you may be selling ice creams instead. So you'll be working full time, right? And now let's assume the following. I'm an investor and I have to make a decision as to whether I want to put my money in a firm that produces ice creams and another one which produces umbrellas. We are in April, so just before the summer, at least in Switzerland, and we have to make some kind of weather forecast and see what the weather is going to be during the summer. So I have to bet that it's going to be a sunny summer, and the firm producing ice creams is going to be very successful and the firm that produces umbrellas is not going to be very successful, okay? So I make my predictions and let's see at the various possibilities there are, in terms of investment. Let's assume that I believe that the summer will be nice, and so I can bet on the firm which produces ice creams. So this would be my first strategy, and it would be a traditional strategy, i.e., I'm long ice creams, I invest in ice creams because I think the stock prices will go up. So the first strategy is long ice creams. Now assume that I don't think the weather will be nice during the summer and I believe that the firm selling umbrellas will be more successful. So my other strategy will be I can be long umbrellas. So this +UM stands for long umbrellas. Now I may be not really knowledgeable in terms of weather forecast and not really know what the weather is going to be. So I may say, all right, hm, I don't know. So I diversify. I put half of my assets in the ice cream firm, and half of my assets in the umbrella firm, and we'll see what happens. So I diversified without knowing who is going to win. And the fourth strategy, and that's the alternative strategy. All the three ones I just talked to are traditional ones, or long only. Basically you're buying, okay? The fourth strategy is the only one which is alternative, in that here we go back to strategy number one, long ice creams. I say not only do I think that the firm producing ice creams is going to make a lot of money because the weather will be nice during summer. But on top of that, I believe the company selling umbrellas will do badly, and I want to bet against that firm. So I'm going to be long ice cream, short umbrella. So this +IC/-UM is this hedge fund strategy of being long a security which I believe will go up and being short a security which I believe will go down. What are the results? We can see that I was right in betting that the summer would be nice. And you see that the company doing ice creams had very good results, 23%. And the firm which produces umbrella, the share price went down and it lost 26% over summer. So not exactly knowing which to choose, the 50/50 strategy means you made half of the gain of the ice cream but also half of the losses of the umbrella, so for a total of -1.5%. The winning strategy is this +IC/-UM, so it's long in the ice cream and short the umbrella. And here I'm assuming that you don't make any leverage, so you're betting half of your wealth on the ice cream and you're betting the equivalent of half of your wealth in shorting umbrellas. So you make half the gain of the 23% on ice cream, and you're making also half the gain of shorting the umbrella stock, for a total of 11.5. So half 23 plus 13, half of the gain by betting against the umbrellas of 13, so for a total of 24.5. Now you saw, in the basic concepts on the performance and return, that we can define risk as the dispersion of the returns. So we call this volatility. And here I've calculated the volatility, how it looks. You see that for the ice creams it's 10.8, for the umbrella is 12.1, for the 50/50 it's 3.9, and for the long ice cream, short umbrella strategy, it's 10.6. It's interesting that this is the main idea of being long and short, is that sometimes you gain on your long positions, sometimes you gain on your short positions, sometimes on both, sometimes on neither, but on balance, you're going to be able to reduce the volatility because basically you're diversifying your investments. And here we see that this 10.6 is actually the lowest of the long ice cream and long umbrella strategies. And we see that the ratio which we call Sharpe ratio, 1% in brackets means it's the risk-free return, so basically what we're doing here is that we're comparing the total return, comparing it to a risk-free asset. So this additional return, we're dividing it by risk. So this is the measure which we call risk-adjusted return. It's a key metric for measuring whether we have paid to deliver this extra return and basically if we're paid to assume all this risk. So the Sharpe ratio gives you the best measure of risk-adjusted return, and we see that it's highest for the long-short strategy, the long ice cream, short umbrellas. [MUSIC]