As investors seek higher alpha, there has been growing interest in the advantages of strategies that incorporate both long and short positions to increase the opportunity set of potential returns. Academic researchers and investment practitioners recognized that loosening the long-only constraint is one of the most effective ways to increase portfolio efficiency, maximize a manager's investment insights and potentially increase alpha generation.¹

Introducing a judicious level of shorting into a portfolio allows a manager to fully express insights on both undervalued and overvalued stocks. This not only increases the investment opportunity set and portfolio diversification, it can also improve returns per unit of risk or information ratios. Managers can short an overvalued security by borrowing the stock from a broker and selling it with the expectation of buying it back at a later date and lower price. They can not only underweight an overvalued security by a margin larger than its weight in the benchmark, they can include larger overweights in underpriced securities without increasing the portfolio's risk level. Shorting a poorly ranked stock makes room in the portfolio for more highly ranked long positions. The proceeds from these short positions are reinvested into excess longs so that 100% investment exposure and beta neutrality are maintained. This is what the 130/30 ratio refers to: 30% extra on the long side due to the addition of 30% on the short side.²

While the theory of these strategies is very attractive, there are several implementation challenges that speak to the advantages of working with managers experienced in taking short positions and monitoring their attendant risks.

Managing Leverage Risk
A new set of risks are introduced with a long/short structure: short positions must be carefully monitored and controlled; leverage can increase volatility; and working with prime brokers adds an additional layer of complexity, not to mention possible UBTI (unrelated business taxable income) issues for some investors.

While judicious shorting can increase a portfolio's efficiency and performance, managing short positions requires a different skill set from managing long-only portfolios. To begin with, the consequences of being wrong on a short position can be much more painful. If a portfolio has a 2% long weight that declines by 20%, money is certainly lost, but the relative size of the position also falls. Further price declines will have an incrementally smaller impact on the portfolio. On the other hand, if the 2% short position rises in value, not only is money lost but the relative position size increases. Further increases can accelerate losses, since they exert a relatively larger impact on the portfolio. This type of price action is beyond the experience of most long-only managers. Those familiar with this dynamic build new controls and trade rules that help mitigate such risks.

In addition, managers need a thorough understanding of the securities lending markets where the shares needed to execute short sales are priced and traded. The inner workings of these markets are unfamiliar to all but the most sophisticated investors as just a handful of Wall Street firms and custody banks dominate the industry. While price and order flow details are carefully guarded, managers need this information to determine which stocks to short and, perhaps more importantly, which ones to avoid shorting. Managers must have the contacts and tools to effectively engage these markets. Clearly managers with extensive experience managing long/short portfolios will have an advantage over long-only managers entering the short arena for the first time.

Investors also need to be mindful that leverage is embedded in long/short structures. Any investment strategy using leverage can have returns that are more volatile than those in unlevered portfolios. Long/short portfolios have two forms of leverage. Borrowing shares to initiate the short positions is one. Borrowing funds to cover the excess 30% long positions (to offset the short positions) is the other, albeit more traditional, form of leverage. In the end, investors have 160% of their capital at work, with the potential volatility that entails.

Working with Prime Brokers
The role of the prime broker is essential in any strategy that shorts securities and is quite different from that of a traditional broker buying and selling stocks. Shares must be sourced and borrowed, and cash proceeds for the sale are held in segregated accounts. Positions must be marked-to-market on a daily basis (similar to futures), taking into account any dividends. (The short seller owes the equivalent value of the dividend to the lender of the short position.) Changes in status, such as corporate actions, mergers, or spin-offs, must be properly handled on behalf of the short seller. And of course prime broker fees must be negotiated, an area where large, established asset managers such as SSgA can have a distinct advantage. For managers new to the business, these all represent additional sources of operational and execution risk that require established relationships, advanced risk management infrastructure as well as management experience and insight.

Unrelated business taxable income (UBTI) is another concern some tax exempt organizations could face with long/short strategies. In essence, these investors are not allowed to borrow funds to earn a profit. Long/short strategies must be properly structured and managed to avoid inadvertently triggering UBTI.

As more investors focus on generating higher alpha, we expect a growing number will recognize the benefits of increasing the flexibility of their investment process by relaxing the long-only constraint and introducing a measure of shorting. Successfully implementing these kinds of long/short strategies requires working with managers who understand and can address specific risks. SSgA has managed equity market neutral strategies and their operational and execution risks since 1990. Our experience with securities lending and major prime brokers has helped us design 130/30 and other long/short strategies in a variety of investment regions including the US, Australia, Hong Kong and the UK.

¹ Clark, de Silva and Sapra (2004) clearly identified the long-only constraint as responsible for the greatest information loss or inefficiency in a portfolio.

² The proportion of shorts versus longs can be adjusted according to client volatility and return objectives. Reasonable levels range can range from 120/20 to 150/50.

SSgA portfolio managers may manage long-only and long-short portfolios for SSgA or its affiliates. SSgA has implemented various safeguards to address potential conflicts of interest.

This material is for your private information. The views expressed are the views of Brian Shannahan only through the period ended April 13, 2006 and are subject to change based on market and other conditions. The opinions expressed may differ from those with different investment philosophies. The information we provide does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. We encourage you to consult your tax or financial advisor. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information. Past performance is no guarantee of future results.

Posted On: April 25, 2006