Equitizing Long - Short Rationale

CFA Level III
#1

Hey all,

This whole equitizing long-short was bugging me. Now I know starting from market neutral position you also get market exposure (beta) by buying futures. So your profits are long alpha, short alpha, plus long beta.

In practice though I just cant figure how am I going to make profits out of this - the main rationale of this. What I mean is

Lets say i go long market (long futures) and market goes up 10%

well lets say my both long and short stocks will go up 10%

I made 10%.

If market goes down 10%, I lost 10%. The thing I dont get is that my long in market always goes against my short stock? Am I missing something.

Well if its the case why not just buy long futures then - if market goes up 10% return 10% vice-versa. Whats the point of being long and short.

I mean whats the scenario when I have short alpha + long alpha + long beta returns more than long beta in practice? Is that possible unless short stock has beta of -1? Or short stock has less beta than long, so that it does not increase in the same way.

#2

The idea is that you are separating the management of alpha and beta management. Your short and long alpha are additive through active stock selection, while you get overall market exposure through the beta portion. You are though to be able to pick the winners (long, positive active positons) and the losers (short, negative active positions or underweights). These ideally will both add value, in addition to a long futures position.

Does that answer your question?

#3

Thanks for your comment - I see your point and understand that in theory.

The thing I am trying to get is, if I am picking winners in long stock I am making alpha, lets say my long appreciates 10% - 10% return.

Let’s say I picked the winner as well in short - price decreased 10% - 10% return

And I am also exposed to market risk - lets say market overall increased 10%.

Now, if both my long and short positioned stocks move up the same rate (10%), then my short profits are eroded. long alpha + long beta = 20% return.

If markets went down by 10%,

Plus short goes 10% down, Short makes 10+10=20%,

Long loses 10%

Beta future loses 10%

0%.

so my upside is only when the market goes up + I was correct with my alphas.

If I were wrong with my alphas

i) short loses 10%, plus market increased 10% lost, long stayed same (10% market up, 10% alpha lost). -10% -> when markets increase

ii) short wins 0% (10% alpha - 10% beta), long loses 10%+10%, beta loses 10%, 30% loss -> when market goes down

If i were market neutral then i’d get 20% if i were correct with two alphas (10% return each) and 0% if i were wrong with one of them. If i am wrong in both I am losing 20%.

Not sure If I am better off, provided the above are correct. Or is the above rationale completely flawed?