The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

CHAPTER 12

Long-Short Equity Portfolios

Bruce I. Jacobs, Ph.D. Principal Jacobs Levy Equity Management

 

Kenneth N. Levy, CFA Principal Jacobs Levy Equity Management

 

 

 

 

 

To create a long-short equity portfolio, the investor buys “winners”—securities that are expected to do well over the investment horizon—and sells short “losers”—securities that are expected to perform poorly. Unlike traditional, long-only equity investing, long-short investing takes full advantage of the investor’s insights. Whereas the traditional investor would act on and potentially benefit only from insights about winning securities, the long-short investor can potentially benefit from insights about winners and losers.²²²

As we will see, by combining long and short positions in a single portfolio, the investor increases flexibility in pursuit of return and in control of risk. This increased flexibility reflects the greater freedom afforded the investor to act on negative insights, and also the freedom from traditional index constraints afforded by the ability to reduce risk by offsetting long and short positions. The potential result is improved performance vis-à-vis a traditional long-only portfolio.

A long-short portfolio also offers increased flexibility in asset management. For example, the investor can choose to construct a market-neutral long-short portfolio, which eliminates systematic (market) risk while providing the risks and returns of security selection. Alternatively, the investor ...