Long-Short Portfolio Management

Abstract

With the freedom to sell short, an investor can benefit from stocks with negative expected returns as well as from those with positive expected returns. The authors explain that the benefits of combining short positions with long positions in a portfolio context, however, depend critically on the way the portfolio is constructed. Only an integrated optimization that considers the expected returns, risks, and correlations of all securities simultaneously can maximize the investor's ability to trade off risk and return for the best possible performance. This holds true whether or not the long–short portfolio is managed relative to an underlying asset class benchmark. Despite the incremental costs associated with shorting, the authors argue that a long–short portfolio, with its enhanced flexibility, can be expected to perform better than a long–only portfolio based on the same set of insights.