Long-Short Equity Investing

Jan 1, 2002

With the burst of the technology bubble and private equity returns plummeting, it is no surprise that hedge funds have become an important asset class for high net worth individuals and institutional investors alike. Recently, cautious institutions such as CalPERS, a $158 billion pension fund, and General Motors have announced their plans to allocate significant capital into this arena.  Of special interest to many institutions are long-short equity strategies. In this article we will examine three popular construction techniques deployed by long-short equity portfolios: pairs trading, stratification and optimization. We will build portfolios using each of these methods and then evaluate their ability to achieve the following two goals: 1) Maximize alpha by purchasing undervalued securities and shorting overvalued securities. This has a significant advantage over long-only equity strategies by allowing a manager to better exploit overpriced securities. 2) Offer risk diversification by creating a short portfolio that reduces the long portfolio's risk. This feature enables the construction of popular 'market neutral' strategies. To evaluate the tradeoff between risk and returns, we will use the Sharpe ratio, defined as the ratio of expected returns to forecasted risk.