A directional strategy is any trading or investment strategy that entails taking a net long or short position in a market. It is betting on the direction the overall market is going to move in. A trader who is net long will benefit from a rise in the market. One who is net short will benefit from a decline. Most long-term investors engage in the simple directional strategy of holding a long portfolio of stocks and/or bonds. Directional strategies are the opposite of market neutral strategies.
Hedge funds that pursue a directional strategy within a particular equity market may be categorized as
- being dedicated short,
- being dedicated long,
- having a dedicated short bias,
- having a dedicated long bias, or
- pursuing a long/short strategy.
A dedicated long or dedicated short directional strategy is, respectively, one of exclusively taking long positions or exclusively taking short positions. Hedge funds that do either are rare. As mentioned earlier, a dedicated long strategy is what most investors pursue. There is little reason to pay hedge fund fees for that directional strategy when it can be implemented less expensively with a mutual fund or other investment manager. Usually, if a hedge fund has a dedicated long directional strategy, it does so in an emerging market that calls for unique expertise.
There were a number of dedicated-short funds during the 20th century. These tended to be run by rugged individualists—men with a reputation for defying conventions. They were pessimists in an optimistic sort of way, anticipating profits from an imminent market decline that rarely transpired. The long-term bull market for US equities forced them out of business. Today, they have been replaced by hedge funds with a dedicated short bias. These combine long and short positions, but they always maintain a net short exposure to the market. They suffer in a rising market, but not as much as a dedicated short fund would. A fund with a dedicated long bias is similar, but it always maintains a net long exposure to the market.
A long/short directional strategy is one of opportunistically having a net long or net short exposure to the market based upon a short-term market view. As with the other strategies, this one seeks to add value through selecting which stocks to go long or short, but it also seeks to add value by deciding when to go net long or net short the market. The strategy should not be confused with a market neutral strategy that combines long and short positions to achieve zero net market exposure.
An equity long/short directional strategy is one example of a more general concept called market timing. This can be pursued in any market—equity, fixed income, commodities, etc.—and is simply a strategy of opportunistically getting in or out of the market based upon a trader’s short-term expectations for that market’s performance. A market timer might opportunistically switch between going long or exiting a given market. If he is more aggressive, he might also sometimes short the market. The term “market timing” is sometimes (but not always) used disparagingly, since most markets are extremely difficult to time. A classic example is the bubble in technology stocks during 1999-2001. Many market professionals knew the market was forming a bubble—that stocks were going to continue surging upwards and then come crashing down. Even with this knowledge, they could not profit from the situation because they didn’t know when the market would turn. If they first went long and then shorted the market too early, they would suffer as the market continued to rise. If they went long and then shorted the market too late, they would suffer when the market fell. Michael Berger’s Manhattan Fund tried to time this bubble but wiped out its capital by going short too early. A market timer needs to accurately predict what is going to happen in a market and when it is going to happen.
Directional strategies can also be implemented across multiple markets. A global macro hedge fund is one that market times different markets around the world. At a given point in time, it might be long US fixed income, short the euro and long Japanese stocks, all at the same time. It will generally use derivatives to create some of its exposures.
To understand where the name “global macro” comes from, consider that a directional manager who trades in a single market hopes to add value through knowing his market well and carefully selecting which instruments to go long or short—he is making microeconomic assessments about individual securities. A global macro manager focuses on identifying which markets to go long or short at any point in time. She is making macroeconomic assessments about entire markets and economies around the world, hence the name global macro.