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

EVALUATING LONG-SHORT

Besides analyzing the operational considerations involved in long-short portfolio construction and management, investors need to evaluate carefully the value-added potential of the security selection approach underpinning it. Any active equity management approach can be adapted to a long-short mode. In the past, investors (including hedge funds) that engaged in short selling tended to focus on in-depth fundamental analyses of specific companies, as they attempted to exploit given situations such as perceived fraud or expected bankruptcy. As short selling began to be incorporated into structured long-short portfolios, however, a more quantitative approach took hold. Today, most long-short managers use a quantitative rather than a traditional judgmental approach.

Traditional judgmental approaches, because of their in-depth nature, are usually limited in the number of stocks they can cover. This in turn limits the range of opportunities that can be exploited by the portfolio. Traditional analyses also generally result in subjective buy, hold, and sell recommendations that are difficult to translate into directions for building portfolios.

By contrast, quantitative approaches can be applied to a large universe of stocks, which tends to increase the number of potential investment opportunities detected. A quantitative process also generally results in numerical estimates of risk and return for the whole range of securities in the universe. Short sale candidates ...