Long short equity hedge fund question

Question

I have a question related to long short equity hedge funds.

1) What are some of the metrics used to perform risk analysis of long short equity funds on fund level? Volatility (standard deviation), sharpe ratio, sortino ratio, net exposure, gross exposure, and maximum drawdown are some metrics I could think of. Are there any other ones I should look into?

2) I am having some trouble differentiating b/w net exposure and gross exposure. From my understanding, net exposure is long position - short position and gross exposure if long position + short position. Also, only net exposure measures market risk, so the higher the net exposure, the higher the market risk. However, I also know that if gross exposure is over 100%, it means it is using leverage. Thus, it should have more risk too, right?

Could you please confirm if my understanding this correct? 1) The higher the net exposure, the higher the market risk is, assuming that funds have the same gross exposure.

Example: Fund A has 70% long, 20% short, so its net exposure is 50% and gross exposure is 90%. Fund B has 90% long, 0% short, so its net exposure if 90% and gross exposure is 90%.

In this case, Fund B has more risk than Fund A because of its higher net exposure (given same gross exposures).

2) The higher the gross exposure, the higher the market risk, assuming that funds have the same net exposure.

Example: Fund A has 70% long, 20% short, so its net exposure is 50% and gross exposure is 90%. Fund B has 115% long, 65% short, so its net exposure if 50% and gross exposure is 180%.

In this case, Fund B has more risk than Fund A because of its higher gross exposure (given same net exposures).

Answer 1

1) You didn't specify whether you're interested in ex post or ex ante risk analysis. But in either case, beta / correlation to the relevant stock market index is really important for long/short equity funds. They could be just leveraged beta plays and providing no alpha, or they could be market neutral and providing only alpha. Looking at exposure or attribution to common factors (e.g. value, quality, etc.) is also important.

2) You're correct that GMV = longs + shorts and NMV = longs - shorts. It's a little too simplistic to say that only NMV measures market risk though. You could have a NMV = 0 book which is long the FAANGs and short gold stocks and it would probably have a positive beta (i.e. market risk).

In general, it's dangerous to compare different funds using just GMV and NMV measures, because a lot depends upon portfolio construction (e.g. how concentrated the long and short books are). Generally, market directional risk is "cheap" risk (i.e. it's easy to get risk with small exposure), and risk from a market neutral book is less "cheap". Thus you may need 2x2 leverage (GMV = 4, NMV = 0) to get the same risk from a market neutral book as from a long-only unlevered book (NMV = 1, GMV = 1). But as I said -- this depends on portfolio construction and it's easy to construct examples where this is not true.

But taking the case of a single portfolio and just increasing either GMV or NMV will increase the risk. For example, a portfolio with NMV = 0 and GMV = 2 will have twice the risk of the same portfolio at half the size (NMV = 0, GMV = 1).