Apologies if someone already asked this, but I didn’t find in search. In Question 21, the answer states that since the alpha of a long-short pair is most likely twice as long-only strategy because one alpha is from the long side and the other one from the short side. My question is, if they take equal positions in two common stocks in the same industry, wouldn’t it cancel out and make the overall alpha lower than the long-only? I understand that there are 2 alphas structurally, but since the correlation of stocks is supposedly high within the same industry, how does that make the alpha twice as much?
the idea is …in the long short strategy…they would be long an undervalued stock and short an overvalued stock… that’s how they get two positive alphas…
It’s not like “long” alpha is positive, and “short” alpha is negative. Alpha is alpha, and you earn it (add it) whether it’s earned on the long or short side. A long / short fund can make bets in any number of securities or industries. They don’t have to be market neutral (market neutral strategies do though). But even market neutral strategies are able to earn two alphas by shorting the overvalued stock and going long on the undervalued stock. A long-only strategy would only be able to make half of that bet.
Yeah… i know that. I guess I’m thinking too much or thinking in the wrong direction. I was assuming that the stocks are correctly valued and in that case if the correlation between the two are high it wouldn’t make the alpha twice as big, but it makes sense to short the overvalued one and long the undervalued one… thanks mumu.
My understanding is that in a long short strategy there will be two alpha and zero beta. The ex-post alpha generated may or may not be positive, depending on the actual movment of the undervalued and overvalued stock vs strike price.