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

Benefits of Long-Only Investing

  • Long-term risk premiums, such as the market risk premium, are earned by investors going net long securities.
  • The capacity and scalability of a long-only strategy is set by the liquidity of the underlying securities. Capacity of short-selling strategies is set by the availability of securities to borrow to facilitate short-selling. This means the capacity of long/short strategies is likely to be lower than for long-only strategies, particularly those large-cap funds that face few long-only capacity issues.
  • Due to limited legal liability laws, the maximum a long investor can lose is the amount they paid for the security (if the security falls to zero). The potential loss to a short-seller is unlimited, however, as they lose as stock prices rise, and stocks prices have no price ceiling.
  • Regulations allow some countries to ban short-selling in the interests of financial market stability.
  • Transactional complexity is higher for a long/short fund.
  • Costs are likely to be higher for long/short funds than long-only funds both in terms of management fees and operational expenses.
  • The personal ideology of an investor might cause them to object to short-selling. This may be because they find the concept of profiting from the failure of others morally wrong, or they believe the expertise to short-sell is not consistently available from managers. Investors may find the leverage involved in some long/short strategies unacceptable.

Long/Short Portfolio Construction

Investors may be interested in long/short strategies for a variety of reasons. For example, the conviction of negative views can be more strongly expressed when short-selling is permitted than in a long-only approach.

In addition, short-selling can help reduce exposures to sectors, regions, or general market movements and allow managers to focus on their unique skill set.

Finally, the full extraction of the benefits of risk factors requires a long/short approach (i.e., short large cap and long small cap, short growth and long value, short poor price momentum and long high price momentum, etc.).

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

Long/short strategies offer the following benefits:

  • Greater ability to express negative ideas than a long-only strategy. The most negative position a long-only manager can take is to not hold a security, meaning that maximum underweighting a long-only manager can take is set by the weight of the security in the benchmark. A long/short manager is not constrained in this way because they can short securities. This will increase the information ratio because lower constraints will increase the transfer coefficient of the manager (TC, measuring their ability to translate insights into investment decisions, as seen earlier in the fundamental law of active management).
  • Ability to use the leverage generated by short positions to gear into high-conviction long ideas.
  • Ability to remove market risk and act as a diversifying investment against other strategies.
  • Greater ability to control exposure to risk factors. Because most rewarded factors (size, value, momentum, etc.) are obtained through a long/short portfolio, being able to short-sell allows managers to better control their exposure to these factors.

Long/short strategies contain the following drawbacks:

  • Unlike a long position, a short position will cause the manager to suffer losses if the price of the security increases.
  • Some long/short strategies require significant leverage, which magnifies losses as well as gains.
  • The cost of borrowing securities can become too high, particularly for securities that are difficult to borrow.
  • Losses on the short position will increase collateral demands from stock lenders, particularly if leverage has been used. This may force the manager to liquidate positions at unfavorable prices. The manager may also be vulnerable to a short squeeze, where a sudden rise in the price of a heavily-shorted security forces short-sellers to cover positions, buy back shares and potentially force the share price higher. Lenders of securities could also recall shares at inopportune times causing disruption to the manager’s strategy.

Long Extension Portfolio Construction.

Long extension strategies are a hybrid of long-only and long/short strategies. They are often called “enhanced active equity” strategies. 

Market-Neutral Portfolio Construction

Market-neutral portfolios aim to remove market exposure through their long and short exposures. Market-neutral portfolio construction attempts to exactly match and offset the systematic risks of the long positions with those of the short positions.

A market-neutral strategy is still expected to generate a positive information ratio. Although market neutral may seek to eliminate market risk and perhaps some other risks on an ex ante basis, the manager cannot eliminate all risks.

Market-neutral portfolios can be constructed through pairs trading, where the securities of similar companies are bought and sold to exploit perceived mispricings. Quantitative approaches to pairs trading are referred to as statistical arbitrage (stat arb).

Market-neutral strategies have two inherent limitations:

  1. Practically speaking, it is no easy task to maintain a beta of zero. Not all risks can be efficiently hedged, and correlations between exposures are continually shifting.
  2. Market-neutral strategies have a limited upside in a bull market unless they are “equitized.” Some investors, therefore, choose to index their equity exposure and overlay long/short strategies. In this case, the investor is not abandoning equity-like returns and is using the market-neutral portfolio as an overlay.

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