Long and Short Security

Long/Short, Long Extension, and Market-Neutral Portfolio Approaches

These approaches are investment strategies that aim to increase returns and manage risk. They are based on research insights and involve both long and short positions in securities.

This approach is based on the belief that research insights can be used to profit from both positive and negative insights gathered during the research process. For instance, if research indicates that the stock of Company A will rise and that of Company B will fall, an investor can buy Company A’s stock (long position) and sell Company B’s stock (short position).

These are constrained long/short strategies. For example, in a long-extension strategy, an investor might invest 130% of their capital in long positions and 30% in short positions, resulting in a net exposure of 100%. This is similar to a long-only portfolio.

Market-neutral strategies aim to eliminate exposure to various risk factors. For example, an investor might hold equal long and short positions in a particular sector, thereby neutralizing the risk associated with that sector.

Long-Only Investing

Long-only investing is a strategy that investors may choose to pursue based on several considerations. This strategy involves buying and holding securities for a long period of time with the expectation of positive returns. It is influenced by following considerations.

1. Long-term Risk Premiums

Long-term risk premiums serve as a significant incentive for investors to maintain a long-only investment strategy. This is based on the widely accepted notion that a positive long-term premium can be earned by bearing market risk. For instance, an investor who consistently invests in the S&P 500 index over a long period can expect to earn a risk premium over the risk-free rate.

Investors may also believe that risk premiums can be earned from other sources of risk. These include Size, Value, or Momentum. To capture these risk premiums, investors must consistently own or go net “long” on the underlying securities exposed to these risks. For example, an investor might go long on small-cap stocks (Size), undervalued stocks (Value), or stocks with strong momentum (Momentum).

Realized Risk Premium Returns

While risk premiums have been proven to yield a return in the long run, realized risk premium returns can be negative in the short run. This is because the market can experience returns less than the risk-free rate. This is also tied to the cyclicality of the Size, Value, and Momentum factors. For instance, during a market downturn, the realized risk premium on small-cap stocks might be negative.

For investors with shorter-term investment horizons, the potential benefits of a positive expected risk premium over the long run may not offset the potential risk of market declines or other reversals. These investors may prefer an approach other than strictly long-only investing and may prefer to short-sell some securities. For example, an investor with a short-term horizon might short sell a stock that is expected to decline in price.

2. Capacity and Scalability in Investment Strategies

The topic of ‘Capacity and Scalability’ is crucial in the realm of investment strategies, particularly in the context of long-only investing. This strategy, especially when focused on large-cap stocks, offers significant investment capacity compared to other approaches.

For instance, consider the MSCI ACWI, which boasts a total market cap of nearly $65.8 trillion, and the 10 largest companies globally, collectively worth $10.4 trillion as of September 30, 2021. For large institutional investors like pension plans, there are virtually no capacity constraints in terms of the total market cap available for long-only large-cap investing.

However, it’s important to note that long-only strategies may face capacity constraints if they focus on smaller, illiquid stocks or employ a strategy reliant on a high level of portfolio turnover.

In contrast, the capacity of short-selling strategies is limited by the availability of securities to borrow. This is a key difference between the two strategies and an important consideration for investors.

3. Limited Legal Liability in Stock Trading

In the field of stock trading, common stocks are financial instruments that offer limited liability. For instance, if an investor purchases shares in Apple Inc., the maximum loss they can incur is the amount they initially invested. The lowest a stock price can fall to is zero, which sets a firm limit on the potential loss for a long-only investor.

Contrarily, short-selling, especially “naked” short-selling, carries a higher risk. For example, if an investor shorts Tesla Inc. shares, they stand to lose money as the stock price rises, and there is no upper limit to how much the price can increase, making the potential losses unlimited.

To mitigate this risk, investors often employ a combination of long-only and short-selling strategies. These long/short strategies are generally considered less risky than strategies that involve only long or only short positions.

4. Regulatory Measures

Regulatory measures are integral to the functioning of financial markets, particularly in the context of short selling. Short selling is a trading strategy where an investor sells assets they do not own, anticipating a price drop, which allows them to repurchase at a lower price and profit from the difference. This strategy, however, is not universally accepted and is subject to varying regulations across different countries.

Some countries prohibit short-selling due to its potential risks and negative impacts on financial markets. These risks include market manipulation and the potential to trigger or exacerbate financial crises. For instance, during the 2008 global financial crisis, short selling contributed to sharp price declines in securities, leading to market panic. Consequently, the UK Financial Services Authority (FSA) and the US Securities and Exchange Commission (SEC) imposed temporary bans on short-selling of financial companies to protect the integrity of the financial system.

Naked Short-Selling

Many countries that permit short-selling have regulations to prohibit or limit naked short-selling. Naked short-selling is a practice where an investor short-sells a tradable asset without first borrowing the security or ensuring that it can be borrowed. This practice is considered riskier than regular short-selling as it can lead to unlimited losses if the price of the asset increases instead of falling.

Regulatory measures, therefore, play a crucial role in maintaining the stability and integrity of the financial markets by controlling potentially risky trading practices such as short-selling and naked short-selling.

5. Transactional Complexity in Investment Management

Transactional complexity is a key component in investment management, focusing on the mechanics of long-only investing and short-selling transactions, and the role of a custodian in these transactions.

In long-only investing, the investment manager instructs a broker or uses an electronic platform to purchase a specific stock, such as Apple Inc. The broker executes the trade and arranges for the security to be delivered to the client’s account. A custodial bank, like JPMorgan Chase, often acts as an intermediary, delivering the cash for the stock and taking possession of the shares. The adviser can liquidate the position at any time, provided the custodian is instructed not to lend out the shares.

Short-selling transactions are more complex. The investor first needs to find shares of stock to borrow, which can be challenging and costly for hard-to-locate shares like Tesla Inc. Investors must also provide collateral to ensure that they can repay the borrowed stock if the price increases. There is a risk that the borrowed stock may be recalled at an inconvenient time.

Role of a Custodian

In many regions, regulated investment entities must use a custodian for all transactions. This involves complex three-party agreements between the fund, prime broker, and custodian, governing the buying and selling of securities and the management of collateral.

Without a custodian, an investor is exposed to counterparty risk. This was evident in the Lehman Brothers bankruptcy, where collateral held in a general operating account of a prime broker vanished. Therefore, operational risk is significantly greater with long/short investing.

Collateral is the security provided by the borrower (investor) to the lender (broker) to secure the borrowed shares. If the price of the borrowed shares increases, the borrower must provide additional collateral to cover the increased value of the borrowed shares.

6. Management Costs in Long-Only and Long/Short Investing

• Long-only investing is generally less expensive than long/short investing, both in terms of management fees and operational costs. For instance, a traditional mutual fund (long-only) may charge a 1% management fee, while a hedge fund (long/short) might charge a 2% management fee.
• Managers of long/short products often charge fees that are significantly higher than those charged by long-only managers.

Types of Long/Short Products

• There are three main categories of long/short products: active extension, market neutral, and directional. For example, an active extension strategy might involve a 130/30 strategy, where 130% of the portfolio is long and 30% is short.

• As of 2021, long/short hedge funds typically charge fixed fees of about 2% and performance fees of about 20%. For instance, a hedge fund with $100 million in assets would charge $2 million in fixed fees and 20% of any profits as performance fees.
• Given these high fees, investors in long/short products must have a high degree of confidence in the manager’s ability to extract premiums or generate alpha. This is especially true when compared to lower-fee, long-only managers.

7. Personal Ideology and Investment Preferences

Investment decisions are often influenced by an individual’s personal ideology. For instance, some investors may lean towards long-only investments for various reasons:

• Ethical considerations: They may view profiting from others’ losses, as in the case of short-selling, as morally wrong. For example, an investor who believes in ethical investing may avoid short-selling a struggling company’s stock.
• Expertise: They may believe that short-selling requires a higher level of expertise than long-only investing, which may not always be available or reliable. For instance, an amateur investor might stick to long-only investments due to their simplicity.
• Risk tolerance: They may argue that short-selling requires significant leverage to achieve the desired long-term expected return, and they may be unwilling to take on this risk. For example, a risk-averse investor might avoid short-selling due to the potential for unlimited losses.
• Investment strategy: In essence, some investors may strictly avoid any investment strategy other than long-only investing.

These are personal beliefs and preferences, and they can vary greatly among different investors.

Long/Short Strategies in Investment

Investors employ long/short strategies for a myriad of reasons. These strategies enable a more robust expression of negative views via short-selling, an option not available in a long-only approach. Short-selling can also mitigate exposure to sectors, regions, or overall market movements, allowing managers to concentrate on their unique skill set. Moreover, a long/short approach is crucial for fully reaping the benefits of risk factors, such as short large cap and long small cap, short growth and long value, short poor price momentum and long high price momentum, and so on.

Styles and Implementation of Long/Short Strategies

There are numerous styles of long/short strategies, each propelled by its own investment thesis. The implementation of these strategies varies based on their intended purpose. In a long-only portfolio construction process, the weights assigned to every asset must be greater than or equal to 0 and the weights must sum to 1. However, in the long/short approach, position weights can be negative and the weights are not necessarily constrained to sum to 1. Some long/short portfolios may even have aggregate exposure of less than 1.

The absolute value of the longs minus the absolute value of the shorts is referred to as the portfolio’s net exposure. The sum of the longs plus the absolute value of the shorts is called the portfolio’s gross exposure.

Equal-Risk-Premium Products and Long/Short Strategies

Long/short strategies are also used in the design of equal-risk-premium products. These products aim to extract return premiums from rewarded factors, often across asset classes. To do this, the manager must create long/short sub-portfolios extracting these premiums (such as Size, Value, Momentum, and Low Beta) and combine these sub-portfolios using weightings that ensure each component will contribute the same amount of risk to the overall portfolio.

Long Extension Strategies

Long extension strategies, also known as “enhanced active equity” strategies, are a unique blend of long-only and long/short strategies. A real-world example of this is the “130/30” strategy, which has seen a resurgence in popularity post the 2008 global financial crisis. This strategy involves constructing a portfolio with long positions worth 130% of the invested capital, while simultaneously holding short positions worth 30% of the capital. The total of the long and short positions equals 100% of the capital. Essentially, the short positions fund the excess long positions, resulting in a gross leverage of 160% (130% + 30%). This potentially allows for greater alpha and a more efficient exposure to rewarded factors.

Advantages and Risks

Long/short investment strategies offer distinct advantages over traditional long-only strategies by utilizing leverage differently. Instead of just borrowing cash to amplify gains from stocks expected to rise, long/short strategies also capitalize on predictions of declines. This dual approach allows for potentially greater total returns but also increases the risk of loss if the predictions prove incorrect in both long and short positions.

• Balanced Insight Utilization: Leverage in long/short strategies is not limited to cash borrowing. It also includes taking short positions in stocks forecasted to underperform, which can theoretically magnify total returns but may increase potential losses.
• Risk of Greater Losses: While aiming for higher returns, there’s a risk that incorrect predictions on both long and short sides can lead to more substantial losses.

The 130/30 strategy is an example of a long/short approach that overcomes certain limitations of long-only portfolios, particularly in expressing negative views on stocks with small benchmark allocations.

• Overcoming Benchmark Limitations: In long-only strategies, managers are restricted to the benchmark allocation of a stock, limiting how negatively they can position themselves. For example, a stock with a 0.25% benchmark allocation can only be excluded entirely, which is the maximum negative position possible under long-only constraints.
• Flexible Weight Adjustments: The 130/30 strategy allows managers to underweight or overweight a stock beyond its benchmark proportion, thereby expressing stronger positive or negative views in line with their insights and expectations.

Market-Neutral Portfolio Construction

Market-neutral portfolio construction is a strategy employed in the investment world to mitigate market risk. This is achieved by balancing long and short positions in such a way that the portfolio’s overall market exposure is as close to zero as possible. This strategy is particularly useful when the investor’s focus is on the manager’s ability to predict returns of stocks, sectors, factors, or geographic regions, without the influence of general market movements. The ultimate goal is to generate positive abnormal returns.

Long/Short Strategies

Long/short strategies are investment tactics where investors take long positions in stocks they expect to appreciate and short positions in stocks they anticipate will decline. For example, an investor might buy shares of Apple (long position) because they believe its value will increase, while selling shares of Tesla (short position) expecting a decrease in its value.

• • Expressing Short Ideas: This strategy allows investors to actively bet against stocks they expect to fall, providing a way to profit from declines in addition to gains.
  • Leverage Efficiency: Long/short strategies can use borrowed money or securities to potentially increase returns, offering a strategic advantage in utilizing available capital.
  • Diversification: By mixing long and short positions, these strategies can spread risk across various assets, reducing the impact of any single investment’s performance.

Long/Short vs Long-Only Strategies

However, a fully invested long-only strategy will be exposed to market risk. To reduce this risk, the manager must either concentrate holdings in low-beta stocks or hold a portion of the assets in cash, an asset that produces minimal return. Conversely, to increase the level of market risk, the long-only manager must own high-beta stocks or use financial leverage; the cost of leverage will reduce future returns. In contrast, a long/short manager has much more flexibility in adjusting his level of market exposure to reflect his view on the current opportunities.

Benefits and Risks of Long/Short Strategies

Despite the advantages, long/short strategies carry several inherent risks:

• The risk of the short position moving against the manager if the price of the security increases.
• The need for significant leverage, which must be used cautiously to avoid excessive risk exposure.
• The potentially high cost of borrowing securities, especially for those that are hard to borrow, which can be prohibitive.
• Increased collateral requirements if a short position moves unfavorably, which can strain financial resources.
• In extreme scenarios, the necessity to liquidate favorably ranked long positions if excessive leverage is employed.
• The danger of a short squeeze, where a rapid and significant increase in the price of a shorted stock forces short investors to close their positions due to unmet collateral demands.

Role of Prime Broker in Short-Selling

When short-selling securities, investors typically rely on a prime broker who can help them locate the securities they wish to borrow. But the prime broker will require collateral from the short sellers to assure the lenders of these securities that their contracts will be honored. The higher the relative amount of short-selling in a portfolio, the greater the amount of collateral required. Different types of assets are weighed differently in the calculation of collateral value. For example, a US Treasury bill may be viewed as very safe collateral and accorded 100% of its value toward the required collateral. In contrast, a high-yield bond or some other asset with restricted liquidity would have only a portion of its market value counted toward the collateral requirement. These collateral requirements are designed to protect the lender in the event of adverse price movements.

Practice Questions

Question 1: A portfolio manager is considering three different investment strategies: Long/Short, Long Extension, and Market-Neutral. He believes that his research insights can be used to profit from both positive and negative insights gathered during the research process. He also wants to ensure that the portfolio’s exposures to a wide variety of risk factors is zero. However, he is not interested in a strategy that is relatively unconstrained in the extent to which it can lever both positive and negative insights. Which investment strategy should the portfolio manager consider?

1. Long/Short Approach
2. Long Extension Approach
3. Market-Neutral Approach

Answer: Choice C is correct.

The portfolio manager should consider the Market-Neutral Approach. This strategy is designed to profit from both increasing and decreasing prices in one or many markets, while attempting to completely avoid exposure to market risk. Market-neutral strategies are often constructed to be beta-neutral, or insensitive to the overall market returns. This is achieved by taking long and short positions in two different securities with a positive correlation. The portfolio manager’s desire to profit from both positive and negative insights aligns with this strategy. Furthermore, the market-neutral strategy’s goal of zero exposure to a wide variety of risk factors also aligns with the portfolio manager’s requirements. However, this strategy does not allow for significant leverage of positive and negative insights, which is in line with the portfolio manager’s preferences.

Choice A is incorrect. The Long/Short Approach allows for significant leverage of both positive and negative insights, which contradicts the portfolio manager’s preferences. This strategy involves taking long positions in stocks that are expected to increase in value and short positions in stocks that are expected to decrease in value. While this strategy can profit from both positive and negative insights, it does not ensure zero exposure to a wide variety of risk factors.

Choice B is incorrect. The Long Extension Approach involves taking a long position in an equity index and a long position in a portfolio of stocks that are expected to outperform the index. This strategy does not allow for profiting from negative insights, as it does not involve taking short positions. Furthermore, it does not ensure zero exposure to a wide variety of risk factors.

Question 2: An investment firm is considering three different portfolio approaches: Long/Short, Long Extension, and Market-Neutral. The firm wants a strategy that is the most encompassing term and can include long extension and market-neutral products. Which portfolio approach should the investment firm consider?

1. Long/Short Approach
2. Long Extension Approach
3. Market-Neutral Approach

Answer: Choice A is correct.

The Long/Short Approach is the most encompassing term and can include long extension and market-neutral products. The Long/Short Approach is a broad investment strategy that involves taking long positions in stocks that are expected to increase in value and short positions in stocks that are expected to decrease in value. This approach allows for a wide range of strategies, including long extension and market-neutral strategies. A long extension strategy involves taking a long position in an equity portfolio and a short position in a subset of the long portfolio, effectively extending the long position. A market-neutral strategy involves taking equal long and short positions in different stocks to reduce market risk. Both of these strategies can be considered as subsets of the broader long/short approach. Therefore, if the investment firm wants a strategy that is the most encompassing term and can include long extension and market-neutral products, it should consider the Long/Short Approach.

Choice B is incorrect. The Long Extension Approach is a specific type of long/short strategy, not an encompassing term. It involves taking a long position in an equity portfolio and a short position in a subset of the long portfolio, effectively extending the long position. While it can be a part of a broader long/short strategy, it does not encompass other types of long/short strategies, such as market-neutral strategies.

Choice C is incorrect. The Market-Neutral Approach is another specific type of long/short strategy, not an encompassing term. It involves taking equal long and short positions in different stocks to reduce market risk. Like the long extension approach, it can be a part of a broader long/short strategy, but it does not encompass other types of long/short strategies.

Glossary

• 130/30 Strategy: A strategy involving long positions worth 130% of the capital and short positions worth 30% of the capital.
• Gross Leverage: The total of the long and short positions in a portfolio.
• Market-neutral portfolio: A portfolio strategy that balances long and short positions to mitigate market risk.
• Pairs trading: A market-neutral strategy where an investor goes long on one security and short on another in the same industry to exploit perceived mispricing.
• Prime Broker: A broker that provides a range of services to hedge funds and other professional investors, including securities lending for short selling.

Portfolio Management Pathway Volume 1: Learning Module 3: Active Equity Investing: Portfolio Construction;

LOS 3(k): Discuss the long-only, long extension, long/short, and equitized market-neutral approaches to equity portfolio construction, including their risks, costs, and effects on potential alphas