I refer to the CFA books and would like someone to explain the following statement. Example prefered. “Disadvantage of short extension strategy – they gain their market return & alpha from the same source. By contrast, with an equitized long short market neutral strategy, it is possible to earn market return & alpha from different source.” Many many thanks, LEE
A market-neutral long-short portfolio ( mnlsp) has only alpha exposure as beta is zero. (i.e. skill based return only). For example lets say investor has created a mnlsp in large cap US stocks. He is not exposed to US Large cap market fluctuations and his returns are based on performance of specific stocks only. Now, if an investor wants to add some beta exposure for a short time (e.g. a month), he can enter in long future position on ANY index. Complete Freedom. He can enter in a long future position on any Russell index, or he may venture into any MSCI index. This position has absolutely nothing to do with his mnlsp. However, in short extension strategy, beta return is earned by having a primarily long exposure in a specific market. Short positions are established in the same market to lower beta exposure and create some alpha exposure. Because if manager establishes short position in different market, this will defeat the whole point. A short position in another market, means no reduction in beta exposure. Rather, portfolio will be exposed to full beta exposure of long position in Market A, negative beta exposure of the new Market B in which short positions have been established and alpha exposure in the new market B. Therefore, in short extension strategy, short positions are established in same market in which portfolio has long position. Therefore, alpha and beta returns are earned from same market.
Thanks for your answers. As I’m not working in the finance sector, I have a further question on alpha & beta separation. Per the CFA books “If investor is explicitly precluded from investing on a long short basis, he can port the manager’s alpha by taking a short position in TOPIX & a corresponding position in S&P 500 futures. The resulting portfolio is S&P 500 plus alpha associated with Japanese equity portfolio.” I understand the beta from S&P 500 & the alpha from Japanese equity. However, does the investor expose to Japanese beta & why? Thanks again
you “port” the alpha (japanese equities) onto the S&P 500 beta… so you (theoretically) get what the manager is INTENDING to achieve. (edit:, that is, beta from S&P, and alpha from jap eq) However, in the real world, it’s almost impossible to get 100% alpha. There’s always some lingering beta component in pure alpha strategies… (not to mention about how alpha is an “ever-evolving term” vis-a-vis beta). But to answer your question: in theory, no; i.e., not exposed to jap beta in practice, yes, i.e. you have some jap beta in the jap alpha piece.
one example to clarify: Assume Portfolio A of long jap equities has beta of 1.1. If you put on a short position of 110% your portfolio value on the futures “market,” say TOPIX, you essentially “equalized the beta” of your Portfolio A, leaving you the “pure” alpha piece from your Portfolio A.
And if the manager is successful in porting this alpha (by continuously rebalancing while also being mindful of trading costs), then you shoudln’t have much beta left in the Jap eq.
Many thanks.