For the sheer fun of it, I’m going to run a small market neutral portfolio for 2008. I intend to use Markowitz CAPM to optimize the portfolio. I’m too stupid to make my own optimizer with 10-20 assets (like I need to have) but I found a shareware app on the internet for $89 that does almost everything I need (input my own expected returns and limit size of holdings). The one problem I’m having is with figuring out the short side. I came up with a possible solution but I haven’t paid the $89 to try it… was wondering if anybody thinks it makes sense or if my idea is just stupid and I should go do something else altogether. Anyway… for the short inputs, can I just take the historical returns of the short candidates and multiply them by -1? That way… when I pass them to the optimizer, it just treats it like any other asset? FWIW, the short candidate will usually be an index ishare. Doesn’t this make sense?
I think you just leave the historical returns as they are. The optimizer will give you negative weights for items you need to short, provided that you have specified that the optimization is unconstrained, or at least permits negative weights. Note that shorting isn’t just the opposite of going long. If the market moves against your short positions, your portfoilio gets even more exposed to adverse movements, so you may need to monitor more carefully and rebalance more frequently.