Long/Short Extensions: How Much is Enough?

32 Pages Posted: 23 Jul 2007

See all articles by Roger G Clarke

Roger G Clarke

Ensign Peak Advisors

Harindra de Silva

Analytic Investors, Inc.

Steven G. Sapra

Analytic Investors, Inc.; Claremont Graduate University

Steven Thorley

BYU Marriott School of Business

Date Written: September 2007

Abstract

Long/short ratios like 130/30 are an increasingly common way for the investment management industry to describe portfolios that are released from the long-only constraint. The ratio of a portfolio's long and short positions to net notional value is often the primary description of the strategy, replacing more traditional measures such as active risk. Unfortunately, managers and their clients may not understand the underlying parameters associated with the value of the long/short ratio, beyond the general recognition that the size of the extensions (e.g., 30 percent) and active risk are positively related. We develop a mathematical model to identify the factors that determine the size of the long/short extension, and illustrate the relationships using historical data on the S&P 500 benchmark, as well as current data on a variety of domestic and international equity benchmarks. The model confirms the basic intuition that the size of the long/short extension increases with the active risk target chosen by the manager, and decreases with the estimated costs of shorting. In addition, the model shows that the expected short extension for an unconstrained portfolio depends on average security risk, average pair-wise security correlation, the security weight concentration of the benchmark, the number of investable securities, and the assumed accuracy of security return forecasts. The model provides important perspectives on long/short strategies as the investment management industry continues to move away from more traditional long-only portfolios.

Keywords: Portfolio Management, Short Selling, Portfolio Optimization

JEL Classification: G11, G23

Suggested Citation

Clarke, Roger G and de Silva, Harindra and Sapra, Steven and Thorley, Steven, Long/Short Extensions: How Much is Enough? (September 2007). Available at SSRN: https://ssrn.com/abstract=1001371 or http://dx.doi.org/10.2139/ssrn.1001371

Roger G Clarke

Ensign Peak Advisors ( email )

60 East South Temple
4th Floor
Salt Lake City, UT 84111
United States

Harindra De Silva

Analytic Investors, Inc. ( email )

555 West 5th Street
50th Floor
Los Angeles, CA 90013
United States
213-688-3015 (Phone)
213-688-8856 (Fax)

Steven Sapra

Analytic Investors, Inc. ( email )

555 W. 5th St.
50th Floor
Los Angeles, CA 90013
United States
213-688-3015 (Phone)
213-688-8856 (Fax)

HOME PAGE: http://www.analyticinvestors.com

Claremont Graduate University ( email )

150 E. Tenth Street
Claremont, CA 91711
United States

Steven Thorley (Contact Author)

BYU Marriott School of Business ( email )

616 TNRB
Brigham Young University
Provo, UT 84602
United States
801-378-6065 (Phone)
801-378-5984 (Fax)

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