A market-neutral portfolio offers an active return from the specific securities the investor selects to hold long or sell short, plus a return representing an interest rate. The neutral strategy does not reflect either the return or the risk of the underlying equity market. As Exhibit 12.2 illustrated, the value added from stock selection skill, represented by the long-short spread, is independent of the performance of the equity asset class from which the securities were selected.
That value added can be transported to other asset classes through the use of derivatives overlays. An investor can, for example, add back the risk and return of the equity market by purchasing stock index futures equal in amount to the investment in the market-neutral strategy. The resulting “equitized” long-short portfolio captures the performance of the underlying market while allowing the investor to benefit from the enhanced flexibility in stock selection afforded by long-short management.
Exhibit 12.3 illustrates the deployment of capital for equitized long-short portfolio construction. Note that the major difference between Exhibit 12.3 and Exhibit 12.1, other than the addition of the $10 million of stock index futures, is the size of the liquidity buffer. As noted, the liquidity buffer is used, among other things, to meet marks to market on the short positions. With an equitized strategy, an increase in the price of short positions induced by a market rise is ...

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