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Abstract:
An analysis of risk, covariance, and correlation is used to measure the implementation losses that arise as a result of transaction costs and investment constraints. Losses are measured relative to an ideal, costless, and unconstrained implementation. The figure of merit is mean-variance expected utility expressed as portfolio alpha minus penalties for active variance and transaction costs. In a general setting, before-cost results are found that define the opportunity loss and identify its sources. In a specific case, after-cost results are found that enable prediction of how expected utility and information ratios are influenced by the investment process, information turnover, risk aversion, and transaction costs.

Portfolio Management, Equity Strategies, Portfolio Construction, Rebalancing and Implementation

Abstract:
Long-short strategies have generated controversy and institutional interest for more than 10 years. We analyzed the efficiency gains of long-short investing, where we defined efficiency as the information ratio of the implemented strategy (the optimal portfolio) relative to the intrinsic information ratio of the alphas. The efficiency advantage of long-short investing arises from the loosening of the (surprisingly important) long-only constraint. Long-short and long-only managers need to understand the impact of this significant constraint. Long-short implementations offer the most improvement over long-only implementations when the universe of assets is large, asset volatility is low, and the strategy has high active risk. The long-only constraint induces biases (particularly toward small stocks), limits the manager's ability to act on upside information by not allowing short positions that could finance long positions, and reduces the efficiency of traditional (high-risk) long-only strategies relative to enhanced index (low-risk) long-only strategies.