McGraw-Hill

available from the portfolio construction process. Through the use
of short sales, for example, one can construct portfolios that ba
equal dollar amounts and equal systematic risks long and short. The
balanced long and short positions neutralize the portfolio‘s exposure
to the underlying market. The portfolio incurs no systematic
risk, nor does it earn the market return.
The long-short portfolio does earn the returns on the individual
securities held long and sold short, and incurs the risks assoc
ated with the individual securities held long and sold short. Both
the portfolio’s overall risk its and overall return should benefit from
the ability to sell short. The result is an improved trade-off between
risk and return vis-a-vis a long-only portfolio.
As we have noted, a long-only portfolio’s ability to underweight
stocks is limited absolutely by the weights of the stocks in
the underlying benchmark. Benchmark weights also constitute the
starting point, for determining the portfolio’s residual risk (the ri
that the portfolio’s performance wil diverge from that of the underlying
benchmark). As departures from benchmark weights,
whether over- or underweights, introduce residual risk, a long-o
portfolio tends to converge toward the weights of the stocks in its
underlying benchmark in order to control risk.
The need to converge toward benchmark weights necessarily
limits the portfolio‘s potential for excess return, as returns in ex
of the benchmark’s accrue only to positions that are over- or
underweighted relative to their weights in the benchmark. Consider,
for example, a stock that constitutes 4 percent of the benchmark.
If the portfolio likewise holds a 4 percent weight, the stock
can contribute nothing to the portfolio’s excess return; the portfolio
weight of 4 percent is totally passive.
In a long-short portfolio in which securities’ market sensitivities
are balanced long and short, there is no benchmark risk, hence
no need to converge to benchmark weights. This not only eliminates
the constraint on security underweights, but frees up capital for investment
in active positions. At the same time, the portfolio’s risk,
reflecting the security-specific risks of the constituent securities, can
be controlled by offsetting the exposures of the securities held long
and the exposures of the securities sold short.
An engineered long-short approach also offers added flexibility
in asset allocation. With a market-neutral long-short portfolio