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

SOME CONCERNS ADDRESSED

Long-short construction maximizes the benefit obtained from potentially valuable investment insights by eliminating long-only’s constraint on short selling and the need to converge to securities’ benchmark weights in order to control portfolio risk. While long-short offers advantages over long-only, however, it also involves complications not encountered in long-only management.

Many of the complications are related to the use of short selling. For example, shares the investor desires to sell short may not be available for borrowing, or shares that have been sold short may be called back by their lenders. Shares sold short are subject to recall by the lender at any time. In most cases, the prime broker will be able to find alternative lenders for the securities subject to recall, but if these are not available, the long-short investor will be subject to “buy-ins” and have to cover the short positions. One also occasionally hears about a “short squeeze,” in which speculators buy up lendable stock to force a buy-in at elevated prices. This will be more of a problem for dedicated short sellers who take concentrated positions in illiquid stocks than for a long-short investor holding small positions diversified across many stocks.

The cost associated with securing and administering lendable stocks averages 25 to 30 basis points. Harder-to-borrow names will require a higher haircut and may even entail negative interest (that is, the short seller pays, rather ...