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

Portfolio managers who have flexibility in their IPS can choose between exclusively buying equities (long-only) or a combination of buying equities and short-selling other equities simultaneously.

The Merits of Long-only Investing

• Long-term risk premium: Achieved solely through net long investments.
• Capacity and scalability: Net long investing's capacity is primarily limited by market liquidity, while short selling is constrained by the availability of borrowable securities. Short selling often has limited capacity and scalability.
• Limited legal liability: Long investors can't lose more than their initial investment, even in worst-case scenarios, whereas short sellers potentially face unlimited losses.
• Regulations: Short selling is banned in certain jurisdictions, making long-only investing a more widely available and dependable option.
• Transactional simplicity: Short selling involves finding shares to borrow, offering collateral, and managing the return of borrowed shares, introducing counterparty risk. Long-only transactions are simpler, usually requiring buying and holding shares.
• Costs: Borrowing shares for short selling can be expensive, especially for hard-to-borrow shares. Additionally, long-short funds often have higher management fees due to the complexity of trading.
• Personal beliefs: Some investors object to profiting from others' failures, while others find short selling's alpha generation less predictable or reliable than net long investing.

Long-Short Portfolio Construction

Net and gross exposure can determine the extent to which a portfolio is long or short. This helps market participants categorize portfolio types and determine a particular style.

Gross exposure is the total amount of securities exposure in a portfolio. It is calculated by adding the sum of the long positions and the absolute value of the short positions:

$$ \text{Gross exposure} = \text{Sum of long positions} + \mid \text{Sum of short positions} \mid
$$

Net exposure is the difference between the total long and short position values.

$$ \text{Net exposure} = \text{Sum of long positions} + \text{Sum of short positions} $$

The difference between the two-exposure metrics lies in the absolute value of the short positions in the gross exposure definition, while net does not include this stipulation. A quick example will help illustrate the point.

A fund has the following exposures to total equity positions:

$$ \begin{array}{c|c|c}
\textbf{Name} & \textbf{Long} & \textbf{Short} \\ \hline
\text{Warringham Fund} & + 100,000 & -100,000
\end{array} $$

The fund has a gross exposure of:

$$
\$100,000 + \mid \$100,000 \mid = \$200,000 $$

The fund has a net exposure of:

$$ \$100,000 + -\$100,000 = 0 $$

Cash positions don't contribute to gross or net exposure calculations because these metrics focus solely on equity exposure.

Long Extension and Market Neutral Portfolios

Long extension portfolios, like the Warringham fund example above, have an equity exposure greater than 100%, funded by short positions. A popular version is the 130/30 portfolio, investing 1.3 times the capital in long equities expected to outperform, with a 0.3 position in short equities expected to underperform. This strategy captures excess alpha and offers more flexibility than long-only portfolios.

Market-neutral strategies aim to hedge systemic risk factors, focusing solely on the manager's stock-picking skill. Pairs trading is a classic example, where an investor goes long on security in an industry and shorts another in the same industry to exploit perceived mispricing. Statistical arbitrage (stat arb) is a quantitative form of pairs trading that uses statistical techniques to identify historically correlated securities that may deviate from their pattern.

Market neutrality is often quantified using portfolio Beta. A beta of 1.0 indicates market risk exposure equal to the benchmark. Adding short positions reduces the portfolio beta, with the goal of bringing it close to zero for market neutrality.

Market-neutral strategies have some problems. One problem is that it's hard to always keep things perfectly balanced when making dynamic investments. Another issue is that when the stock market is doing really well (like a bull market), these strategies might not make as much money because they're designed to be safer.

The Benefits and Drawbacks of Long-short Strategies

• Express Negative Ideas: You can easily bet against assets you think will perform poorly.
• Use Leverage: You can use borrowed money to make your bets on assets you think will do well, which can magnify your gains.
• Diversify: Long-short strategies can help spread your investment risk and balance your portfolio.
• Control Risk: You have more control over how much risk you want to take.

Drawbacks of Long Short Strategies

• Unlimited Losses: You could potentially face unlimited losses on short positions.
• Leverage Needs: These strategies might require significant leverage.
• Borrowing Costs: Borrowing securities can be expensive.
• Collateral Demands: Losses on short positions can increase collateral requirements.

Question

Which statement is most likely true regarding investing strategies?

1. Long-short investing is often associated with favorable regulatory treatment.
2. Long-short investing benefits from limited liability.
3. Long-only investing benefits from limited losses.

Solution

The correct answer is B.

Statement B is correct in the sense that long-short investors have limited liability in each position, but it's important to consider the potential for substantial losses.

A is incorrect. Long-short investing involves taking both long (buying) and short (selling) positions in assets. While it can be a legitimate investment strategy, it is not necessarily associated with favorable regulatory treatment. Regulatory treatment can vary depending on the specific structure and jurisdiction, and it's not inherently favorable or unfavorable.

C is incorrect. Long-only investing involves buying assets with the expectation that they will appreciate in value. While losses are limited to the amount invested in each asset, they are not inherently limited as with long-short investing. In fact, long-only investors can experience significant losses if the assets they hold decrease in value, and their potential for gains is constrained to the upward movement of the assets.

Reading 26: Active Equity Investing: Portfolio Construction

Los 26 (h) 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