Handbook of Finance: Investment Management and Financial Management

Chapter 33. Long-Short Equity Portfolios

BRUCE I. JACOBS, PhD

Principal, Jacobs Levy Equity Management

KENNETH N. LEVY, CFA

Principal, Jacobs Levy Equity Management

Abstract: One of the principal components of equity investing is the portfolio construction process. In particular, constraints on portfolio construction, including limits on the investment universe and on portfolio residual risk, can have profound effects on portfolio performance. One of the more common, and significant, limitations imposed on equity portfolios is the constraint on short selling—the requirement that a portfolio hold only long positions. Allowing an equity portfolio to sell securities short can enhance performance by improving the portfolio's pursuit of return and control of risk. It is vital, however, that the long-short portfolio be constructed using an integrated optimization that considers long and short positions simultaneously. This is true for market-neutral long-short portfolios, equitized long-short portfolios, and enhanced active equity strategies such as 120-20 and 130-30 portfolios.

Keywords: equity investing, portfolio construction, constraints, residual risk, portfolio performance, short selling, controlling portfolio risk, risk control, integrated optimization, market-neutral long-short portfolios, equitized long-short portfolios, alpha transport, enhanced active equity portfolios, 120-20, 130-30

To create a long-short equity portfolio, the investor buys "winners"—securities that are expected ...