McGraw-Hill

The Long and Short on Long-Short 345
used to control residual risk, are fully consistent with the prudence
and diversification requirements of ERISA.
A meaningful evaluation of long-short calls for an objective
balancing of the real costs against the real benefits. Those benefits
may reflect greater inefficiencies on the short of side the market but
are not dependent on them. The benefits arise from the added flexibility
that long-short affords in control of risk and pursuit of return,
via the elimination of index constraints, and in asset allocation, via
the liberation of security selection return from the underlying equity
class return.
Do the benefits outweigh the costs? The rewards to a longshort
portfolio, like those to any active strategy, will depend ultimately
upon the insights that underlie its security selections. Good
insights will yield good results, whether to a long-short or longonly
strategy. Long-short can enhance those results, however, by
enhancing implementation of the insights.
ENDNOTES
The authors thank Judith Kimball for her editorial assistance.
1. Balancing equal dollar amounts long and short is often desired as a
means to achieve market neutrality, and it is also the optimal
investment posture under certain conditions. For simplicity,
assuming the same constant correlation between all securities, longshort
balance is optimal when the equation holds:
where c and d are functions of the correlation, the number of
securities, and the summation of the inverse of the c, S, and
p = expected excess return of security i
c f = variance of security ~s excess return
N = number of securities
We thank Harry M. Markowik for this insight.
Under the further, although somewhat restrictive, simpliig
assumption that all securities have the same constant variance, the
equation reduces to