The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

CONSTRUCTING A MARKET-NEUTRAL PORTFOLIO

In a market-neutral portfolio, the investor holds approximately equal dollar amounts of long and short positions. Of course, careful attention must be paid to the securities’ systematic risks: The long positions’ price sensitivities to broad market movements should virtually offset the short positions’ sensitivities, leaving the overall portfolio with negligible systematic risk. This means that the portfolio’s value will not rise or fall just because the broad market rises or falls. The portfolio may thus be said to have a beta of zero. The portfolio is not risk-free, however; it retains the risks associated with the selection of the stocks held long and sold short. The value-added provided by insightful security selection, however, should more than compensate for the risk incurred.²²³

EXHIBIT 12.1 Market-Neutral Deployment of Capital (millions of dollars)

Source: Bruce I. Jacobs and Kenneth N. Levy, “The Long and Short on Long-Short,” Journal of Investing 6, no. 1 (1997): 73–86.

Exhibit 12.1 illustrates the operations needed to establish a market-neutral equity strategy, assuming a $10 million initial investment. Keep in mind that these operations are undertaken virtually simultaneously, although they will be discussed in steps.

The Federal Reserve Board requires that short positions be housed in a margin account at a brokerage firm. ...