MSc Investment Management Portfolio Management

Lecture 4 Long/Short Investment

February, 15, 2012

Long and Short Portfolio Construction Techniques

Portfolio construction techniques: being dedicated short
being dedicated long (typical mutual fund strategy) having a dedicated short bias having a dedicated long bias or pursuing a long/short strategy

A dedicated long or dedicated short strategy is, respectively, one of exclusively taking long positions or exclusively taking short positions. Hedge funds that do either are rare. A dedicated long strategy is what most investors pursue. Little reason to pay hedge fund fees for that strategy when it can be implemented less expensively with a mutual fund or other investment manager. Usually, if a hedge fund has a dedicated long strategy, it does so in an emerging market that calls for unique expertise. 2

Long and Short Portfolio Construction Techniques

There were a number of dedicated-short funds during the 20th century

Nowadays, they have been replaced by hedge funds with a dedicated short bias. These combine long and short positions, but they always maintain a net short exposure to the market. They suffer in a rising market, but not as much as a dedicated short fund would.
A fund with a dedicated long bias is similar, but it always maintains a net long exposure to the market.

Long/Short equity investing

A long/short strategy is one of opportunistically having a net long or net short exposure to the market based upon a shortterm market view. As with the other strategies, this one seeks to add value through selecting which stocks to go long or short, but it also adds value by deciding when to go net long or net short the market Not linked to market levels as this strategy has low correlation with traditional investments and provide excellent diversification benefits These portfolios do not always have zero market risk Most have long bias It is estimated that long-short strategy is used to manage more than 40% of assets under management in hedge funds
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Why Long/Short equity investing?

Most of the institutional investors do not capitalise on overvalued stocks Overvalued side of the market is LESS efficient

If that is the case: one sided view of the market

Position in the long and short portfolio is an active position

Increased popularity of market neutral funds i.e. long-short portfolios all market neutral portfolios are long-short, but not necessarily all long-short portfolios are market neutral More efficient way to generate alpha
Long-short investing is used as absolute-return strategy or as a way of transporting alphas
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CAPM, APT and short-selling

Equilibrium models assume no restrictions on short-selling In the real world: investors have less than full use of cash proceeds from the short sales
they may not receive the interest rebate on the proceeds from short sale they may have to put cash or securities as a collateral for the shorted position

some stocks cannot be shorted

shares not available uptick rule lifted since July 2007, modified uptick rule introduces in February 2010 institutional investors have concerns about short selling
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The impact of restricted short-selling on the market equilibrium

Depends on the fact whether investors have homogeneous beliefs about expected returns of a security According to whether short selling is restricted or not and whether investors beliefs are homogeneous or not, we can distinguish four possible cases (please see the grid on the next slide): 1. If all investors have homogeneous beliefs, they hold the market
portfolio and there is no short-selling 2. If beliefs are homogeneous, restricting short-selling has no impact, investors still hold the market portfolio 3. If beliefs are diverse and short-selling is unrestricted, market portfolio is efficient 4. If beliefs are diverse and short-selling is restricted, arbitrage opportunities exist and market portfolio is not efficient
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Short-selling and market equilibrium grid

INVESTOR OPINION
UNIFORM DIVERSE

Market portfolio is SHORT SALE efficient. UNRESTRICTED CAPM and APT hold (no one shorts) Market portfolio is efficient CAPM and APT hold

Market portfolio is efficient. CAPM and APT hold Market portfolio is NOT efficient CAPM and APT DO NOT hold

SHORT SALE RESTRICTED

Long/Short Investment Strategies: Market Neutral Strategy

Market neutral is a strategy very popular with hedge funds
holding long and short equity portfolio in equal pound (dollar, euro) balance at all times buy undervalued and short-sell overvalued securities long portfolio has to have the same beta as the short but of the opposite sign the effect of such a strategy is creation of zero-beta portfolio
no co-movement of the portfolio with the overall market in effect, the market risk is immunised

profits are made from the performance spread between stocks held long and stocks sold short and from the interest received on proceeds of the short sale
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Theoretical payoff pattern for Long and Short portfolio

Payoff from a long active portfolio only: long portfolio which is composed of undervalued stocks has greater return than the market portfolio by the value of alpha
when the market returns are increasing, portfolio returns are increasing as well but more than the market returns when the market returns are decreasing, portfolio returns are decreasing as well but less than the market returns

Payoff from a short active portfolio: short portfolio has greater returns than the short market portfolio by the value of interest received on the proceeds from short-sale and the value of alphas

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Theoretical payoff pattern for Long and Short portfolio

LONG PORTFOLIO
portfolio return alpha interest

SHORT PORTFOLIO
portfolio return alpha

market return long market portfolio short market portfolio

market return

market + alpha = long portfolio

short market portfolio + interest market +interest+ alpha =short portfolio

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Theoretical payoff pattern for Market Neutral portfolio

Payoff from a market neutral portfolio
derived from the long and short portfolio patterns payoff line is horizontal and it intercepts the y-axis at the level of 2 alphas plus the interest from the proceeds of short-sales
Double alpha: one alpha is from the long portfolio and the other one is from the short one assumption: full amount of capital is invested both long and short
portfolio return market neutral portfolio 2*alpha + interest market return

Long portfolio

Short portfolio

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How is the market-neutral strategy implemented?

Once the candidates for the long/short portfolio are selected, the implementation can begin Regulations require short positions to be housed in a margin account at a brokerage firm 90% of capital is used to purchase attractive stocks and to sell-short unattractive stocks
securities bought are delivered to the prime broker and serve as the collateral for the shorts

Prime broker is clearing trades and arranging to borrow stock for short-selling
shares may come from the brokers inventory of shares held or may be borrowed by the broker from a stock lender

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How is the market-neutral strategy implemented? cont.

Short-sales of borrowed securities result in cash proceeds which are posted as collateral with the stock lender to provide security for the borrowed shares

Remaining 10% of capital is retained as liquidity buffer to meet daily gains or losses (marked to market) on the short position liquidity buffer is interest earning
Collateral with the stock lender is adjusted daily to reflect the changing value of shorts if price of shorts increases, marking to market is negative and the lender is provided additional capital to be fully collateralized again and vice versa
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How is the market-neutral strategy implemented? cont.

Cash proceeds of the short sales earn interest The portion of this interest is paid to the lender as a securities lending fee, the portion is paid to prime broker to cover expenses and provide profit
usually, the short-seller receives interest at the value of a T-bill rate interest earned by short-seller called interest rebate

Therefore, the return of the market neutral strategy is approximately equal to a performance spread between longs and shorts plus the Treasury bill rate of return
When the long-short performance spread is equal to zero, market neutral strategy produces returns equal to T-bill rate Hence, T-bill rate is the appropriate benchmark for market neutral strategy
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Outcomes for investors if market-neutral strategy is implemented correctly If implemented correctly, it is the most risk-efficient asset available because: Correlation of market neutral with other assets is zero No exposure to systematic risk Evidence shows that adding different percentages of market neutral portfolio to the S&P 500 index portfolio reduces risk more than if we construct a portfolio of medium-term government bonds and S&P 500. Risk of a market neutral manager is all risk specific to the particular manager can be diversified away portfolio of several market neutral managers might be the most efficient asset choice of all - manager of manager funds
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Long-short investment strategies: The Equitised Strategy Portable Alpha Portable alpha (equitised) strategy
In addition to the long-short portfolio as in market neutral strategy, the investor is holding the stock index futures overlay in the amount equal to the invested capital
achieving the full market exposure at all times

Profits are made from the long-short spread as in market neutral in addition to the profits or losses which are the consequence of the markets rise or fall

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Theoretical payoff pattern for Portable Alpha (Equitised) portfolio

portfolio return portable alpha portfolio

market portfolio
market return

2 alpha

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Implementation of the portable alpha strategy

Mechanics is identical with market neutral, but stock index futures overlay is added Futures are bought in the amount equal to the capital to equitise the long-short portfolio Futures contracts also have marking to market

daily gains or losses in the futures markets tend to be offset by the daily gains or losses on the short portfolio smaller buffer is more adequate in this case
Stock index futures are priced so as to provide return approximately equal to the index return plus the dividend less the cost of carry at about a T-bill rate
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Returns from the portable alpha strategy Alpha Transport

However, when we add the interest earned from the long-short portfolio to the change in futures price, the return obtained is approximately equal to the return of the market index

The value-added (alpha) is the same as in the market-neutral strategy however, the futures overlay transports the long-short spread to the benchmark market index Equtisation (portable alpha) delivers the best of the two worlds: equity returns and market-neutral alpha
Alpha transport should not be restricted to equity only Appropriate benchmark is adequate stock market index if strategy is using equity only
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Long-short investment strategies: The Hedge Strategy

Hedge strategy
in addition to the long-short portfolio as in market neutral strategy, the investor has a variable equity market exposure based on the market outlook
achieved through stock index futures additional profits are made through the changing futures position: long position in futures if expecting rising market and short futures if expecting falling market

Implementation is the same as for the portable alpha (equitised) strategy

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Theoretical payoff pattern for Hedge portfolio

portfolio return

Hedge Portfolio

2 alpha

market return

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Long/Short Investment Strategies: Statistical Arbitrage

Statistical arbitrage: employs time series analysis methods to identify relative mispricings between stocks Typical technique is pairs trading:
Pairs of stocks whose prices tend to move together are identified. If the historical price relationship between them is ever violated, a long/short position is established in the two stocks in anticipation of the relationship being re-established.

The rationale: the abnormal price move was caused by an investor trading on spurious information. Individual pairs will generally not be market-neutral, but the overall portfolio of pairs can be managed to be market neutral.

However, the focus of the strategy is more short-term than equity market neutral.
Exposures to other factors such as industry or market capitalization may not be as tightly controlled.
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Alternative Long/Short investment strategies

Fixed Income Arbitrage: generally implemented to be duration neutral, but they are exposed to various other market risks such as tilts in the term structure, spread risk and foreign exchange risk. Capital structure arbitrage: seeks to profit from inconsistencies in the relative pricing of a firm's debt and equity

Convertible arbitrage: exploits mispricings of a firm's convertible bonds relative to the underlying stock
Convertible bonds have complex exposures to interest rates, the issuer's credit quality, liquidity spreads and the issuer's stock price. This makes them extremely difficult to price. Hedge funds develop sophisticated pricing methodologies and go long or short in convertible bonds they perceive to be mispriced relative to the underlying stock. To maintain market neutrality, they will generally hedge the position with positions in the issuer's debt and/or equity
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Alternative Long/Short investment strategies

130/30 strategy See extra reading material for detailed notes on this

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Advantages of long/short investment strategies: a case of

having one manager instead of two
Strategy avoids wasting assets Precludes excessive risks arising
one manager can purchase oil stocks and the other manager can sell airline stocks magnifying oil price risk

Enables the capital to work twice as hard as with separate long and short managers
with separate long and short managers and 1 of capital, each

would have only 50p to invest

Paying fees for one manager rather than two

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Disadvantages of the long-short investing

Long/short investing has costs and risk
however, they can be controlled long-short management fees should be no higher than the fees per active dollar (pound) invested under long-only management most long/short managers will accept performance-fee arrangements

Unique costs associated with shorting financial intermediation costs of borrowing shorts Investors discomfort with shorting The method of identifying mispriced securities is subjective
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Disadvantages of the long-short investing strategy

High turnover: each portfolio component will have a turnover (long and short), resulting in a 25% increase in turnover compared to long only strategy Risk of managers possessing no skill Problems with beta estimation
if beta is not close to zero, portfolio is not market-neutral the beta estimate depends on the level of diversification of the portfolio more error in the beta of individual stock than in the beta of a portfolio

Common factor risks may be matched (sensitivity to interest rate changes, unexpected inflation etc)
In this case, the sensitivity of the long portfolio to a particular risk factor should be very similar, ideally the same as that one of the short portfolio
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Problems associated with short-selling

Securities can be sold short only on the uptick rule (higher price than the last trade) or a zero plus tick rule (the same price as the last trade but higher than the last trade at a different price)
Causing incremental trading costs because of possible delays in shorting Lifted in July 2007 alternative uptick rule from February 2010 to restrict short selling from further driving down the price of a stock that has dropped more than 10 percent in one day

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 Risk of short-selling there must be someone who owns the stock and who is willing to lend it since the borrowed stocks have to be returned, one may lose more than a 100% of a normal long purchase Short-selling ban in September 2008 (lifted in January 2009): was it useful? Ways of reducing risk of short-selling
1. Do not hold large short positions in individual stocks but rather hold short position in a diversified portfolio 2. Short only stocks with sufficient lending ability 3. Understand the shorting procedure and how the manager deals with it if you are an investor
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Quantitative vs. fundamental method: the candidates to long or short

selection of

Majority of managers are quantitative in their investment approach

models can be applied to the large number of stocks trying to identify largest long/short spread shorts will be the lowest ranked stocks in terms of Jensens alphas for example and longs will be the stocks with highest historical alphas Shorts can be growth and longs can be value stocks for example Forecasting models can be used

Fundamental approach:
in-depth company analysis (fundamental analysis) of a smaller number of stocks limits the range of opportunities and reduces the performance spread helps to detect fraud, negligence, window-dressing
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Practical issues
Is short selling appropriate strategy for investors with long-term horizons? In the long -run, stock markets follow an upward trend Trading issues securities can be sold short only on the uptick (higher price than the last trade) or a zero plus tick (same price as the last trade but higher than the last trade at a different price) rebalancing and controlling transaction costs

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Some of the market neutral players

Starts with Jacobs-Levy Equity Management in 1990
largest and best known long/short equity player initial performance fabulous: 27.8% in the first year however, misvaluation of small cap stocks in 1992/93 has caused the returns of a fund to fall 3.7% below their benchmark

In 1999, disappointing returns

Market was growth oriented, many market-neutral managers shared value biases

LTCM collapse in 1998

Hedge funds are the main funds that implement this type of strategies
Hegde funds lost 18.3% in 2008 Large by assets: GS, BGI, Paulson & Co., Citadel, etc.
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Reading
The Long and Short on Long-Short, by Bruce I. Jacobs and Kenneth N. Levy, The Journal of Investing, Spring 1997; and abstracted in The CFA Digest, Fall 1997.(4) Enhanced Active Equity Portfolios Are Trim Equitized Long-Short Portfolios, by Bruce I. Jacobs and Kenneth N. Levy, Journal of Portfolio Management, Summer 2007; and abstracted in CFA Digest, February 2008 20 Myths About Enhanced Active 120-20 Strategies, by Bruce I. Jacobs and Kenneth N. Levy, Financial Analysts Journal, July/August 2007, and abstracted in CFA Digest, November 2007 Long/Short Equity Investing, by Bruce I. Jacobs and Kenneth N. Levy, The Journal of Portfolio Management, Fall 1993; abstracted in The CFA Digest, Winter 1994; also translated in The Security Analysts Journal of Japan, March 1994.(5) All articles available from http://www.jacobslevy.com/ls.htm (where you will find a few more relevant readings and references)
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