5.4. Active Management on Steroids: Market Neutral Portfolios

In the previous section, we mentioned that the consistent requirement not to stray too far from the index requires institutional equity managers to hold what amounts to a hidden index subportfolio. This is designed to minimize the risk of large differences in performance between the portfolio and the index. In effect, only a portion of the total invested capital is available for implementing the investment decisions, whether they are made by quantitative or traditional means. It is the classic trade-off of risk and return. The maximum return you can realistically expect goes up as the risk you are willing to tolerate (in terms of deviation from the index) increases. If no deviation is tolerated, the portfolio becomes an index fund and no excess return is possible.

There is a way around this. You can put all the invested capital to work in an attempt to add value with a market neutral long-short portfolio. A $100 million long-short, market neutral portfolio consists of $100 million in long positions and $100 million in short positions. Notice that since you get $100 million from the short sale, spend $100 million on the long side, and had $100 million to start, you still have $100 million in cash. There's no net capital required to put on a position such as this. This cash will earn roughly a T-bill return from the brokers. If this cash is left earning short-term interest, the value added by the long and short positions ...

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