McGraw-Hill

284 Expanding Opportunities
and “losing” securities. Portfolios that cannot sell short are restricted
in their ability to incorporate insights about losing securities.
For example, a long-only portfolio can sell a if loser, it happens
to hold the stock, or it can refrain from buying a loser. But, in e
case, the potential impact on portfolio return relative to benchmar
is limited absolutely by the weight of the security in the benchmark.
Consider, for example, that the typical stock in a broad market
index constitutes about 0.01 percent of that index‘s capitalization. Not
holding the stock (or selling it from a portfolio) thus gives the portfolio
a 0.01 percent underweighting in the stock, relative to the underlying
benchmark’index. This is unlikely to give the portfolio’s return much
of a boost over the underlying benchmark, if even the stock does end
up performing poorly. Furthermore, it does not give the manager
much leeway to distinguish between gradations of negative opinions;
a stock about which the manager holds an extreme negative view is
likely to have roughly the same underweight as a stock about which
the manager holds only a mildly negative view.
Shortselling removes this constraint on underweighting. Significant
portfolio underweights can be established as easily as portfolio
overweights. The ability to short thus enhances the manager’
ability to implement the insights gained from the analytical proce
The ability to short proves particularly attractive when overpriced
stocks (potential candidates for short sale) less are efficiently
priced than underpriced stocks (potential candidates for purchas
This may be the case in markets in which short-selling is not widespread.
In such markets, prices tend to adjust to investor pessimism
less efficiently than to investor optimism. Finding overpriced sec
rities to sell short may prove a more rewarding endeavor than fin
ing underpriced stocks to purchase.
Hedge funds and some investors have long recognized the
tential benefits of shorting selected issues in certain market enviro
ments. Jacobs Levy Equity Management was among the first mone
managers to exploit the potentials of short-selling within the framework
of disciplined, engineered equity management. Engineered
long-short portfolios offer the benefits of shorting within the riskcontrolled
environment of quantitative portfolio construction.
Within this environment, short-selling can be used not only to
enhance the implementation of insights from the stock selection
process, but also to expand the profile of risk-return trade-offs