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Long-Short Investing

 


Copyright 2006, Institutional Investor Journals. Reproduced and republished from Journal of Portfolio Management with permission.  All rights reserved.

 


Copyright 2007, CFA Institute. Reproduced and republished from Financial Analysts Journal with permission from CFA Institute. All rights reserved.

Enhanced Active Equity Strategies: Relaxing the Long-Only Constraint in the Pursuit of Active Return
by Bruce I. Jacobs and Kenneth N. Levy, The Journal of Portfolio Management, Spring 2006

 

20 Myths About Enhanced Active 120-20 Strategies
by Bruce I. Jacobs and Kenneth N. Levy, Financial Analysts Journal, July/August 2007

Hedge funds and a limited number of other investors have long recognized the potential benefits of shorting selected issues in certain market environments. Jacobs Levy Equity Management was among the first money managers to explore the potential of short selling within the framework of quantitative equity management. Such long-short portfolios offer the benefits of shorting within the risk-controlled environment of quantitative portfolio construction.

The articles in this section discuss the construction of portfolios that take advantage of short selling to expand investment opportunities and enhance performance. Short selling can be used to enhance the implementation of insights from the stock selection process. It expands the list of implementable ideas from “winning” securities to “winning” and “losing” securities.

Short selling can also expand the profile of risk-return tradeoffs available from the portfolio construction process. Through the use of short sales, for example, one can construct portfolios that balance equal dollar amounts and equal market-relative risks long and short. The balanced long and short positions neutralize the portfolio’s exposure to the underlying market. The long-short portfolio earns the returns on the individual securities held long and sold short. “20 Myths About Long-Short” discusses some of the misperceptions that arise when one views long-short investing through a long-only lens.

“Enhanced Active Equity Strategies: Relaxing the Long-Only Constraint in the Pursuit of Active Return” discusses long-short strategies that use the full cash proceeds from short sales to purchase equal amounts of securities to hold long. The article describes these strategies, including 120-20 portfolios, and gives concrete examples of their benefits over long-only strategies. Enhanced active equity strategies permit meaningful security underweight positions while retaining full market exposure.

These types of strategies are explored further in “20 Myths About Enhanced Active 120-20 Strategies.” Compared with long-only portfolios, both enhanced active long-short portfolios and market-neutral long-short portfolios offer investors greater flexibility to underweight stocks and to diversify risk. Compared with market-neutral long-short portfolios, however, enhanced active portfolios maintain full exposure to the underlying market and allow for the expansion of long positions.

Key Articles:

· “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. (1) article
Enhanced active equity strategies, including 120-20 and 130-30 portfolios, have become increasingly popular as managers and investors search for new ways to expand the alpha opportunities available from active management. But these strategies are not always well understood by the financial community. How do such strategies increase investors’ flexibility both to underweight and overweight securities? How do they compare with market neutral long-short strategies? Are they significantly riskier than traditional, long-only strategies because they utilize short positions and leverage? This article sheds some light on many of the common “myths” regarding enhanced active equity strategies.


·
“Enhanced Active Equity Strategies: Relaxing the Long-Only Constraint in the Pursuit of Active Return,” by Bruce I. Jacobs and Kenneth N. Levy, The Journal of Portfolio Management, Spring 2006. (2) article
Enhanced active equity investing relaxes the long-only constraint by permitting short sales, while maintaining full exposure to equity market return and risk. The enhanced active equity approach is facilitated by modern prime brokerage structures that allow investors to use the proceeds from short sales to purchase long positions. Freeing equity portfolios from the long-only constraint can enhance performance by permitting meaningful underweight positions that are simply not achievable in long-only portfolios. The investor can thus more fully exploit security valuation insights.


Other Articles:

· “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. article
How does an enhanced active equity strategy such as a 120-20 or 130-30 portfolio differ from an equitized long-short strategy—that is, a market neutral long-short portfolio with an equity market overlay? This article looks at the relationship between enhanced active equity and equitized long-short portfolios and demonstrates that an enhanced active equity portfolio can be shown to have an equivalent equitized long-short portfolio, but the enhanced portfolio has the advantage of being more compact and requiring less leverage.

· “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.(3) article
By balancing long positions in equities with short positions of roughly equal dollar amount and market sensitivity, it is possible to construct a portfolio whose return is neutralized against overall market moves. Properly constructed, using an integrated optimization process, a long-short portfolio offers advantages over long-only portfolios in enhanced flexibility to pursue return, control risk, and allocate assets. Any additional costs should not outweigh the benefits of such a strategy.

· “20 Myths About Long-Short,” by Bruce I. Jacobs and Kenneth N. Levy, Financial Analysts Journal, September/October 1996. article
Popular conceptions of long-short investing are distorted by a number of myths, many of which appear to result from viewing long-short from a conventional investment perspective. Long-short portfolios differ fundamentally from long-only portfolios in construction, in the measurement of their risk and return, and in their implementation costs. Furthermore, long-short portfolios allow greater flexibility in security selection, asset allocation, and overall plan structure.

· “More on Long-Short Strategies,” by Bruce I. Jacobs and Kenneth N. Levy, Financial Analysts Journal, March/April 1995 (letter in response to Richard Michaud, “Are Long-Short Equity Strategies Superior?” Financial Analysts Journal, November/December 1993 and to follow-up letter by Robert Arnott and David J. Leinweber, “Long-Short Strategies Reassessed,” and Michaud's “Reply,” Financial Analysts Journal, September/October 1994). article
Some argue that a long-short portfolio can improve upon the risk-return tradeoff of a long-only portfolio only if it reduces risk via the diversification benefits of a less-than-one correlation between the alphas of the long and short components. But this conclusion rests on the assumption that the long component of the long-short portfolio, the short component, and the comparable long-only portfolio are essentially identical, index-constrained portfolios. When long and short positions are chosen simultaneously, however, in an integrated optimization, the result is a single portfolio that is not constrained by index weights. With freedom from index constraints, the manager enjoys added flexibility, vis-à-vis a long-only manager, in implementing investment insights. This should translate into improved performance.


· “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.(4) article
Investors who have the flexibility to invest both long and short can benefit from both “winners” and “losers.” This will be especially advantageous if the latter—the short-sale candidates—are less efficiently priced than the winners—the purchase candidates. This is likely to be the case in markets in which investors hold diverse opinions and short selling is restricted. Short positions can be combined with long positions to create market-neutral, hedge, or equitized strategies. Practical issues include restrictions on shorting, trading requirements, custody issues, and tax treatment.

Books:

· Equity Management: The Art and Science of Modern Quantitative Investing, Second Edition, by Bruce I. Jacobs and Kenneth N. Levy, forewords by Harry M. Markowitz, Nobel Laureate, McGraw-Hill, New York, 2017.

· Equity Management: Quantitative Analysis for Stock Selection, by Bruce I. Jacobs and Kenneth N. Levy. McGraw-Hill, New York, NY, 2000. Authorized Chinese translation from English language edition, McGraw-Hill, China Machine Press, 2006.

This new edition of Equity Management reflects 30 years of research and investment practice by two pioneers of quantitative equity investing. In the 1980s, Bruce Jacobs and Ken Levy published in peer-reviewed journals a series of articles on detecting and exploiting the factors that significantly influence stock returns. Since then, they have examined short selling in the context of long-short portfolios, optimization of portfolios with short sales or other leveraged positions, markets in crisis, and models that can simulate realistic market behavior.

Equity Management: The Art and Science of Modern Quantitative Investing includes the classic 15 articles from the original edition plus 24 articles that were published since the first edition appeared. Together, they present a compelling argument for the benefits of a quantitative approach in a complex, multidimensional, and dynamic factor world.

The chapters are grouped into eight parts, with introductory material that places each section within the broader context of the investment body of knowledge. Part 1 examines the intricacies of stock price behavior and focuses on detecting the characteristics, or factors, behind them. Security prices are neither efficient nor random and unpredictable. Rather, the market is a complex system, permeated by a web of return regularities. These regularities must be "disentangled" to arrive at the real sources of return. This requires analyzing numerous promising return-predictor relationships simultaneously.

Part 2 looks at how best to exploit the investment opportunities detected. The chapters outline a holistic approach that is multidimensional and dynamic. Viewing the market as integrated allows for greater breadth of investigation and greater depth of analysis, hence enhances the potential for more and better insights. A dynamic, multidimensional, proprietary approach that can adapt to changes in the underlying environment is better poised to capture opportunities than an approach that restricts itself to a small number of well-known and static factors.

Part 3 examines how short sales can expand investment opportunities and improve performance. Balancing long and short positions within a portfolio creates a market-neutral portfolio whose performance should reflect the returns and risks of the constituent securities, but not the performance of the overall market. The return from security selection can be transported to virtually any asset class via derivatives, allowing the investor to take advantage of manager skill, wherever it lies, while maintaining any desired asset allocation.

Part 4 focuses on another long-short approach—enhanced active equity, or 130-30 type portfolios. These portfolios retain full exposure to the market return, while pursuing excess returns via short positions and leveraged long positions. The development of 130-30 type portfolios was motivated by Jacobs and Levy’s research into optimization of long-short portfolios, which showed that the optimization process should consider long positions, short positions, and any benchmark holding simultaneously.

The authors also tackled a problem that arises when optimizing portfolios that contain both long and short positions. As the chapters in Part 5 explain, the factor or scenario models of covariance that simplify the optimization process for long-only portfolios do not necessarily apply to long-short portfolios. Jacobs and Levy, working with Harry Markowitz, provide a solution they call “trimability.”

Part 6 addresses the unique risks of leverage, which are distinct from the risk captured by standard deviation, or volatility; most notable is the risk that a margin call can force the unwinding of positions. The mean-variance model central to modern portfolio theory does not consider these unique risks and can thus lead to “optimal” portfolios with very high leverage. The authors present an alternative model—mean-variance-leverage optimization—that allows an investor who is both volatility-averse and leverage-averse to assess the utility of a portfolio.

High levels of leverage almost led to the demise of hedge fund Long-Term Capital Management in 1998 and to the disruption of the entire financial system in 2008-2009. Part 7 examines these episodes and other periods of market crisis, including the 1987 stock market crash. One conclusion is that products and strategies that promise increased returns at reduced risk have attracted investors, encouraged leverage, and too often precipitated not only their own demise, but also the near-collapse of the global economy.

Part 8 presents work undertaken with Harry Markowitz on a model for simulating market behavior. The Jacobs Levy Markowitz Market Simulator (JLMSim) allows users to create their own market models from the bottom up by specifying the numbers and types of market entities, including portfolio analysts, traders, and investors, as well as their decision rules. The results so far suggest that types of investors (value versus momentum), as well as trading rules, can have significant impacts on market stability.


Copyright © 2017


Copyright © 2000


Chinese Translation
Copyright © 2006

· Market Neutral Strategies, by Bruce I. Jacobs and Kenneth N. Levy, Eds. John Wiley & Sons, Hoboken, NJ, 2005.
Market neutral strategies have gained attention in recent years for their potential to deliver positive returns regardless of the underlying market's direction. Market Neutral Strategies provides readers with insiders' views of the risks and benefits of these strategies and how they can be implemented. The book covers long-short equity portfolios, convertible bond hedging, merger and mortgage arbitrage, and sovereign fixed-income arbitrage. Additional chapters cover the tax implications of market neutral investing for taxable and tax-exempt investors; the “transportation” of alpha from a particular market neutral strategy to other asset classes; and the failure of two notorious “market neutral” hedge funds, Askin Capital Management and Long-Term Capital Management.

Copyright © 2005

Book Chapters:

· “Long-Short Equity Portfolios,” by Bruce I. Jacobs and Kenneth N. Levy, in Frank J. Fabozzi and Harry M. Markowitz, Eds. The Theory and Practice of Investment Management. John Wiley & Sons, Hoboken, NJ, 2011. Earlier versions appeared in Frank J. Fabozzi, Ed. Handbook of Finance, Volume II: Investment Management and Financial Management. John Wiley & Sons, Hoboken, NJ, 2008; and in Frank J. Fabozzi, Ed. Short Selling: Strategies, Risks, and Rewards. John Wiley & Sons, Hoboken, NJ, 2004.
Combining long and short positions in a single portfolio increases flexibility in pursuit of return and control of risk. This increased flexibility reflects the greater freedom to act on negative insights afforded by the ability to sell short as well as the freedom from traditional index constraints afforded by the ability to offset long and short positions. Long-short portfolios also offer increased flexibility in asset management.

· “Using a Long-Short Portfolio to Neutralise Market Risk and Enhance Active Returns,” by Bruce I. Jacobs and Kenneth N. Levy, in Ronald A. Lake, Ed. Evaluating and Implementing Hedge Fund Strategies, 3rd Edition. Euromoney Institutional Investor PLC, London, U.K., 2003 (also in 2nd Edition, 1999).
A market-neutral long-short portfolio is constructed so that the dollar amount of securities held long equals the dollar amount of securities sold short and the short positions' price sensitivity to market movements equals and offsets the long positions' sensitivity. Because the portfolio's value does not rise or fall just because the broad market rises or falls, the portfolio is said to have a beta of zero. This does not mean the portfolio is riskless; it will retain the risks associated with the selection of the individual securities held long and sold short. But, with insightful security selection, the portfolio can reap commensurate rewards.

Conference Proceedings and Other Media:

· “20 Myths About Enhanced Active 120-20 Strategies,” FAJ Webcast, September 19, 2007. Webcast
Enhanced active equity strategies, including 120-20 and 130-30 portfolios, have become increasingly popular as managers and investors search for new ways to expand the alpha opportunities available from active management. But these strategies are not always well understood by the financial community. How do such strategies increase investors’ flexibility both to underweight and overweight securities? How do they compare with market neutral long-short strategies? Are they significantly riskier than traditional, long-only strategies because they utilize short positions and leverage? This article sheds some light on many of the common “myths” regarding enhanced active equity strategies.


· “Controlled Risk Strategies,” by Bruce I. Jacobs, in Terence E. Burns, Ed. ICFA Continuing Education: Alternative Investing. Association for Investment Management and Research (today the CFA Institute), Charlottesville, VA, 1998.(5)
Long-short investing is a controlled risk strategy that allows the manager to act on all of his or her investment insights without regard to benchmark constraints. Long-short is not an asset class, but a portfolio construction method in which the manager neutralizes market risk by balancing the average betas of short and long positions in the portfolio. Long-short increases the manager's flexibility to pursue return and control risk. The manager can overweight or underweight stocks by as much as his or her insights (and client risk tolerances) allow. Furthermore, the manager can use offsetting long and short positions to fine-tune overall portfolio risk. This added flexibility should be reflected in portfolio performance. Long-short portfolio performance can be “transported” to virtually any asset class. For example, a long-short portfolio can be “equitized” using stock index futures; the equitized long-short portfolio will reflect the risk and return of the broad equity market and the flexibility advantages of its long-short component. Operational considerations that need to be considered before implementing a long-short strategy include margin requirements, the size of the liquidity buffer, trading requirements, management fees, and taxes.

· “A Long-plus-Short Market-Neutral Strategy,” by Bruce I. Jacobs and Kenneth N. Levy, in Diana R. Harrington and Robert A. Korajczyk, Eds. ICFA Continuing Education: The CAPM Controversy: Policy and Strategy Implications for Investment Management. Association for Investment Management and Research (today the CFA Institute), Charlottesville, VA, 1993.
Investors who can invest both long and short can benefit from both “winners” and “losers,” gaining alpha from both sides. Furthermore, there are reasons to believe that selling short losers may have more profit potential than buying winners; this will be the case in a market characterized by diverse investor opinions and restrictions on short selling. Long and short positions can be combined in market-neutral or “equitized” portfolios; a market-neutral portfolio's performance is independent of underlying market moves, while an equitized portfolio retains exposure to the market. Any active equity management style can be implemented in long-short mode, but quantitative approaches have some advantages. Long-short strategies do not constitute a separate asset class; they can be categorized by existing asset classes, so that their fit in an overall investment program becomes apparent.

Industry Press Publications:

· “Market-Neutral Strategy Limits Risk,” by Bruce I. Jacobs and Kenneth N. Levy, Pension Management, July 1995.
This is a basic primer on long-short strategies. Balancing long and short positions in a portfolio can virtually eliminate the portfolio's exposure to broad market movements.

· “The Generality of Long-Short Equitized Strategies: A Correction,” by Bruce I. Jacobs and Kenneth N. Levy, Financial Analysts Journal, March/April 1993 (letter in response to C.B. Garcia and F.G. Gould, “The Generality of Long-Short Equitized Strategies,” Financial Analysts Journal, September/October 1992). article
An erroneous assumption about margin requirements gives rise to the conclusion that the maximum achievable alpha from a fully invested long-short equitized strategy is 2.48 alpha. The current initial margin requirement for each equity position in a margin account, either long or short, is 50%. The theoretical maximum alpha achievable in a long-short strategy is thus 2. Given realistic constraints on futures margins and cash requirements, the practical maximum is 1.8.


Other Research Categories:

Security Selection

Plan Architecture and Portfolio Engineering

Portfolio Optimization, Short Sales, and Leverage Aversion

Market Simulation

Market Crises

___________________________________________

(1) Presented in a CFA Institute webcast, September 2007, www.cfawebcasts.org/cpe/what.cfm?test_id=717. 2007 Financial Analysts Journal Graham & Dodd Award and Graham & Dodd Readers’ Choice Award winner. Included on the investment reading list of the Institute of Actuaries, UK, June 2008. Reprinted in Modern Portfolio Management: Active Long/Short 130/30 Equity Strategies, by Martin L. Leibowitz, Simon Emrich, and Anthony Bova, John Wiley & Sons, Hoboken, NJ, 2009.
(2) Presented at Goldman Sachs Equity Conference on “Remodeling the Investment Process – A Progress Report and Challenges Ahead,” September 2006. Featured in “New Approach Gets Hedge Fund Returns with Traditional Risk,” by Barry B. Burr, Pensions & Investments, June 12, 2006.
(3) Presented at the Institute for Quantitative Research in Finance (Q-Group) Seminar on “Long/Short Strategies in Equities and Fixed Income,” Fall 1995.
(4) Highlighted by Nobel laureate Bill Sharpe in Sharpe, Alexander and Bailey, Investments, 5th Edition, 1995.
(5) Required CFA reading.

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