Long-Short, Long Extension, & Market Neutral Portfolio Construction
During the 2008 global financial crisis, trillions of funds were lost as the market fell significantly. Yet not all of that money just disappeared, as some of it went into specific funds that use active management strategies to earn excess returns from taking negative positions. What strategy would benefit the most from the market going down?
Exactly.
By shorting stocks, the manager is taking a negative position in an equity hoping that it goes down. This approach would have definitely benefited from the global financial crisis. Yet for most investors, the choice of using variations on a long-only portfolio comes down to several key factors.
Incorrect.
Being leveraged to long stocks is going to hurt performance more than just being long, so that's not a benefit.
Not quite.
Taking no active market risk means that you own the benchmark, so there are still losses as the market goes down.
For example, the investor/manager must consider the long-term risk premiums, where investors believe that they are compensated for holding risky assets over the long term. While studies have shown that investors do earn a return over time, in the short term (like during the financial crisis), realized risk premiums can be negative given the cyclicality of the market and specific factors like size, value, and momentum. Knowing this, what approach may be beneficial for a short-term investor?
Not quite.
The short-term investor still wants to earn an acceptable rate of return.
Incorrect.
A long leverage position can be even more painful for investors if the market cycles to negative.
Correct.
By selling short securities, short-term investors may reduce the risk of market declines that could hurt asset values. In addition, long-only strategies can be impacted by capacity and scalability. Thus, a focus on smaller or illiquid securities, along with portfolio turnover strategies, can face capacity constraints. In contrast to the ability to short stocks, long-only strategies have limited legal liability in the amount that can be lost (since only the amount invested can be lost). For short strategies, the amount of loss can be unlimited. For this reason, many investors combine long and short strategies.
Another consideration is the regulatory constraints on short-selling that make long-only approaches the only option for some investors. In particular, this can be an issue in times of significant market stress. Plus, long-only investing is generally less expensive than long–short strategies because there are some additional issues in managing a long–short fund. What other issue may increase costs associated with a long–short fund?
No.
Diversification doesn't increase cost specifically for a long–short fund.
Incorrect.
Larger opportunity sets usually decrease costs.
Right!
Establishing long–short fund positions is more complex than regular long-only positions. For example, a long-only fund will instruct a broker or use a platform to buy the stock, settle the trade, and deliver the cash to pay for it. Then the manager is free to sell the shares whenever. In contrast, a short sale is much more complex. In this transaction, the manager must locate the shares to borrow, provide collateral, and then sell the stock. Plus, the short seller has additional risk in the fact that stock could be called back, and there is possible counterparty risk if a custodian isn't used. If a custodian isn't used, the collateral can potentially vanish, so operational risk is significantly higher for long–short investing.
A final consideration for long-only investors contemplating long–short exposures is simply philosophy. For some investors, gaining from the losses of others feels morally wrong, while others believe that it takes special management skills to achieve long-term success shorting stocks. Plus, many strategies require leverage to earn the targeted long-term return, and some investors aren't comfortable with taking that risk.
However, for those investors that are comfortable with taking on short positions, there are several benefits, like expressing negative views, reducing sector/region/market exposures, and the ability to fully extract the benefits of risk factors (short large cap and long small cap, etc.). These benefits can be captured in multiple long–short strategies that vary in their implementation and intended purpose. For example, the weights of a long–short portfolio aren't required to equal 1, which is a distinct difference from the long-only portfolio. How might a long–short portfolio achieve weights less than 1?
Incorrect.
Leverage weightings will result in a portfolio that has weights greater than 1.
Exactly.
A long–short investor will take negative weightings or short positions in equities to achieve a different total weighting sum. This means that the weights aren't constrained to sum to 1. The absolute value of the longs minus the absolute value of the shorts is called the portfolio's net exposure. Adding the absolute value of the longs and the shorts is called the gross exposure.
Incorrect.
Just holding the market index benchmark will result in weightings that equal 1.
For many managers, using a long–short strategy allows them to target specific factors using sub-portfolios that weight each factor to contribute the same amount of risk across the portfolio and achieve the most efficient combination. In any strategy, however, long–short managers usually define their exposure constraints by gross and net, with the net usually being positive. Think back to the definition of the net exposure. If the net exposure is greater than zero, how would you describe the portfolio's exposure to the market factor?
That's not it.
There's still some market exposure with a positive net exposure.
Right!
A positive exposure to the market factor means that the net exposure is above zero, so there's more long exposure than short exposure. This net long exposure is also a feature of a long extension portfolio or enhanced active strategy. Under this approach, a manager builds a long portfolio of over 100% and supplements it with a short portfolio that brings the net exposure to 1. Many times, this ratio is 130/30, where the 30% of short capital funds the 30% of long capital. The goal is that the 160% of gross leverage earns a greater alpha and is more efficient in rewarding factors. Plus, the manager can express both positive and negative opinions symmetrically by shorting some stocks to earn higher total returns.
Incorrect.
The net exposure is calculated as absolute long exposure less absolute short exposure, so it's not negative exposure to the market factor.
Another form of a long–short portfolio is the market-neutral portfolio, where the goal is to hedge out most market risk. Note that this doesn't necessarily mean equal amounts invested long and short (that's dollar neutral). Instead, the investor wants to remove the effects of general market movements from returns to explicitly focus on the manager's skill in forecasting. What's another way to describe this strategy?
Exactly.
The investor wants to remove market noise that market movements create to ensure that the manager's skill can create abnormal returns. But, as you can imagine, this strategy is risky, especially in times of rising stock prices that the investor won't participate in. To remove the market's noise, the manager tries to exactly match and offset the systematic risks of the long positions with those of the short positions across a variety of risk factors. Essentially, the objective is to neutralize risks that the manager has no advantage forecasting so that the manager can concentrate on very specific risks.
No.
The manager wants to remove general market movements so that the manager's skill is evident. That's not a passive strategy.
No.
The investor's goal is to remove general market exposure.
Even though the portfolio is essentially market neutral, the manager still expects to generate a positive information ratio and lower volatility. For example, a pair trading strategy can reduce sector or industry volatility when a manager goes long one security and short another security in the same sector. A statistical arbitrage strategy can reduce volatility where a divergence in the correlation between two usually highly correlated securities offers an opportunity. In a third type of strategy, a multi-factor model can evaluate all the securities in the investment universe, and the manager will buy the most favorably ranked and short the least favorably ranked.
But as with any strategy, there are also limitations. For a market-neutral strategy, it's difficult to maintain a beta of 0 since not all risks can be hedged and correlations are constantly changing. Plus, market-neutral strategies have limited upside in bull markets, which is why some investors use market-neutral strategies as an overlay. These limitations are also joined by other risks for shorting securities like the security moving higher, the leverage requirement, the high costs of borrowing, and the collateral requirements. In the case of collateral requirements, these can also lead to other issues with positions that have done well. What might the manager be required to do if the short position moves against the manager?
No.
The manager essentially has a capital call, so they're prohibited from buying new equities.
Right!
If the manager's short positions are failing, then the manager may have to liquidate long positions that are doing well to cover the collateral call. This can also create a short squeeze, where the price of the stock rises so much and so quickly that many short investors may be unable to maintain their positions in the short run in the face of increased collateral requirements. So creating and maintaining short positions is risky.
Incorrect.
The manager must deposit funds into the account if the collateral can't cover the losses in the portfolio.
To sum it up:
Long-short strategies are useful when shorting stocks can unlock additional returns. There are several considerations for long-short investors including risk premiums, capacity and scale, legal liability, risk appetite, regulatory constraints, transactional complexity, management costs, and personal ideology. Long extension and market-neutral portfolios are two types of short strategies.
Shorting stocks
Leveraging long stocks
Taking no active market risk
Cash only approach
Short-sell approach
Long leverage approach
Diversified holdings
Larger opportunity sets
Transactional complexities
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Taking negative weightings
Taking leverage weightings
Holding the market index benchmark
Hedged
Positive
Negative
Investors want to remove market noise
Investors want to establish passive-only portfolios
Investors want to participate in broad market activity
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Buy new long positions
Sell favorable long positions
Sell additional equities short
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