Aspects of Constrained Long-Short Equity Portfolios

Abstract

Fiduciary institutions are forging ahead to remove the traditional long-only handcuffs that constrain the delivery of maximum net alpha by their equity managers. The proliferation of 130/30 managers (long 130% and short 30%, with beta 1.0) prompts a question as to the optimal ratio for these constrained long-short strategies. Analysis of the range from long-only to fully unconstrained will help find the optimal solution that maximizes the risk-adjusted return. The ratio that maximizes net information ratio (IR after leakages) depends largely on the risk budget, the chosen benchmark, leveraging costs, and the transaction costs associated with turnover. In the case of normal active risk (3%-5%), more alpha leverage is better than less. That is, despite the declining marginal benefit of higher leverage, 150/50 may be better than 120/20, approximating a pure market-neutral strategy.