Dollar-neutral funds have an equal amount of dollars long as they have dollars short (essentially a market-neutral fund). So the short positions finance the purchase of the long positions. This means that the portfolio holds cash equal to the dollar value of the longs (or shorts). Suppose you have a return stream from this dollar-neutral fund. You are the portfolio manager and want to lever up the return series. How does the PM do this since the fund is always in a positive cash position? It seems like investors in the fund could do this synthetically (by borrowing to make their investment in the fund) but the PM cannot.
You wrote: “So the short positions finance the purchase of the long positions”
So how would you have cash left over ?
Either you have cash or you finance the long positions , but not both , am I right?
If your question is what do you do with investor cash , then my answer would be , nobody would let you short and keep 100% of the proceeds . You would at the most have 50% with the rest as margin . So the implication would be you are leveraged about 50% on the longs.
But it all depends on the fund’s borrowing ability, right? For instance, if the fund can borrow an amount equal to 100% of their assets, then they can do 2x leverage. Or am I interpreting your question incorrectly?
leveraging would increase the risk & it would not remain market neutral. text says:
In order to magnify the difference in alphas between two stocks, long–short managers (in particular hedge fund managers) sometimes leverage their capital as much as two to three times using borrowed money. Although leverage magnifies the opportunity to earn alpha, it also magnifies the possibility that a negative short-term price move may force the manager to liquidate the positions prematurely in order to meet margin calls (requests for additional cap- ital) or return borrowed securities
I agree that leveraging increases risk, but I’m not sure how this is no longer market neutral.
from the risk perspective you could eliminate systematic risk from your portfolio ( in practice beta close to zero). Then your strategy would only depend on the strength of your stock insights i.e. your alpha model.
You depend on the longs increasing in value because they’re undervalued by the market but also you depend on shorts reducing in value because they’re overvalued by the market. If this convergence isn’t happening , you’d review and generate trades so you try and keep it balanced and systematic-risk-free. In other words you’d have to delta hedge often enough to keep risks low
I hinted at financing ur long position thru short selling. As mentioned above we may requred to keep 50% cash margin than we can only use 50% of short position to finance buy position. If leverage 2X, then after keeping margin we may able to buy our long position. But by leveraging 2x, we would not remain risk neutral. Is in it?..we are 100% exposed on long position but by short selling 200% just double?
I don’t think you should incorporate marging into your calculation as there are ways to gain short exposure without having to post margin.
Even if you do post margin at say 50%, what if you invest the 50% you have left in a double long ETF? then you are still mkt neutral.
But tell me one thing - as mentioned in the text.
In Long-short mkt neutral you earn return on long postion & short position & the risk free return on cash generated from short position (supposing it is kept in T bills, if the margin is applicable then the residual amount).
You dont finance the long position from short. Do you?.
When ramdabom talked about “So the short positions finance the purchase of the long positions.” He is just talking about the possibility or is this what the text says when having mkt neutral L/S strategy?
I think its not beyond one of the realm of possibilities but would like whether this is how it is meant in text.
Using a short position to finance the purchase of a long position reminds me of a zero cost collar, where you sell a call to finance the purchase of a put, thereby hedging your position. But in the text I don’t recall ever reading about a zero cost market neutral position.
My sense is that the scenario you described above is not what is meant in the text. Instead, in a market neutral position you finance the long position from funds already on hand, and not from funds received from a short position.
When ramdabom talked about “So the short positions finance the purchase of the long positions.” He is just talking about the possibility or is this what the text says when having mkt neutral L/S strategy?
You CAN use the short proceeds to finance your long positions, but you don’t have to. In a mutual fund you can’t, but in an unregistered product you can do anything you want within the client’s guidelines. There are other ways to create long or short exposures than to invest actual dollars though (options, futures, swaps, etc).
In a long/short fund, only the exposure to the long and short are the same, but this doesn’t mean that the actual dollar amount invested in both long and short strategies are the same.
Example: you can short $1,000,000 market value of an security in a particular industry, but enter into a long future contract with a notional of $1,000,000 in a different security in the same industry.
If you post margin @ 50% then your initial portfolio would consist of: $500,000 cash, $500,000 in the margin account, short securities worth -$1,000,000 and a futures contract worth 0. The actual amount invested is -$1,000,000 but your exposure nets to 0.
Thnx FinNinja for explaination.
One more query, how does it happen in shorting security. I mean do you get amount equal to short security in your account (offcourse after deducting the necessary margins) which can be put to use either to buy the long position (possiblilty ) or you can invest that in T-bill as stated in text.
In this strategy (keeping text wording in mind) you use your funds to buy long position, you short to become market neutral (though you still unsystematic risk) & invest proceeds from short in T bill to earn risk free return.
One more thing. How do you get risk free return by shorting the future of the owned stock. I mean one way of thinking is like whatever you earn on the owned stock should be given away in the short position (assuming underlying future replicates the movement - since here our position is opposite we have to give away return earned here to long side)
One way of thinking would that since your position is risk less (i.e. you are positioned against both side movement in stock ) now atleast you should be able to earn risk free return otherwise there is no incentive to follow into such strategy.
Any sharing of views Guys : CPK, Jana, Hank moody, FinNinja & others. Thnks!
A while ago I ran correlations of returns of market-neutral funds to S&P 500 for the period between Jan 1994-Dec 2010. When only posiitve months were considered, correlation was 0.11. When only negative months were considered correlation went up to 0.25. That could be explained by the fact that the cost of borrowing goes up when stock market crashes. Market-neutral funds are market-neutral during “normal” times and leverage destroys that when liquidity dries up.
Neva mind I got the concept now as to how we earn risk free return if you own the stock & short the futures