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

THE IMPORTANCE OF INTEGRATED OPTIMIZATION

The ability to sell short constitutes a material advantage for a market-neutral investor compared with a long-only investor. Consider, for example, a long-only investor who has an extremely negative view about a typical stock. The investor’s ability to benefit from this insight is very limited. The most the investor can do is exclude the stock from the portfolio, in which case the portfolio will have about a 0.01% underweight in the stock, relative to the underlying market (as the median-capitalization stock in the Russell 3000 universe has a weighting of 0.01%). Those who do not consider this to be a material constraint should consider what its effect would be on the investor’s ability to overweight a typical stock. It would mean the investor could hold no more than a 0.02% long position in the stock—a 0.01% overweight—no matter how attractive its expected return.

The ability to short, by increasing the investor’s leeway to act on his or her insights, has the potential to enhance returns from active security selection. The scope of the improvement, however, depends critically on the way in which the portfolio is constructed. In particular, an integrated optimization that considers both long and short positions simultaneously not only frees the investor from the nonnegativity constraint imposed on long-only portfolios, but also frees the portfolio from the restrictions imposed by securities’ benchmark weights. To see this, it is useful ...