How to manage long-only and short-only portfolios

Long-only and short-only portfolios each have their importance and can provide different benefits for investors. A combination of these two strategies can help to increase returns while minimizing losses. How to manage long-only, short-only portfolios. We share our insights.

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• Long-only portfolios
• Benefits of the long-only portfolios
• Some examples of the long-only portfolios
• Short-only portfolios
• How profitable short-only portfolios
• How to manage risk in short-only portfolios
• Transforming long-only portfolio into short-only portfolio
• Summary

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Long-only portfolios

Long-only portfolios are more traditional and involve buying securities with the expectation that they will increase in value. This approach can be effective for harvesting style premia by evaluating stocks against several lowly-correlated styles, thus potentially over-weighting certain securities based on expected performance. Long-only portfolios are generally more straightforward and less complex than other strategies.

Among the benefits of the long-only portfolios are:

Simplicity and Ease of Understanding:

• Long-only portfolios are straightforward and easy to comprehend.
• Investors buy and hold assets with the expectation that their prices will appreciate over time.

Participation in Market Upside:

• By investing in long-only assets (such as stocks), investors benefit from market rallies and economic growth.
• As the market rises, the value of their holdings increases.

Dividend Income:

• Many long-only investments, especially stocks, provide regular dividend payments.
• Dividends contribute to overall returns and can be reinvested for compounded growth.

Passive Investing:

• Long-only strategies align well with passive investing approaches.
• Investors can build diversified portfolios using index funds or exchange-traded funds (ETFs).

Lower Transaction Costs:

• Long-only portfolios typically involve fewer transactions compared to active trading.
• Lower turnover results in reduced brokerage fees and taxes.

Risk Management:

• Long-only investors can manage risk by diversifying across different asset classes and sectors.
• Holding a mix of stocks, bonds, and other assets helps mitigate individual security risk.

Behavioral Benefits:

• Long-only investing encourages a disciplined approach.
• Investors are less likely to make impulsive decisions based on short-term market fluctuations.

Historical Performance:

• Over the long term, equity markets have shown positive returns.
• Long-only investors who stay invested benefit from compounding growth.

Tax Efficiency:

• Long-term capital gains tax rates are often lower than short-term rates.
• Holding assets for an extended period can lead to tax advantages.

Avoiding Short-Selling Risks:

• Long-only portfolios avoid the complexities and risks associated with short selling.
• Short positions can lead to unlimited losses if stock prices rise unexpectedly.

Some examples of the long-only portfolios:

Quantitative Long-Only Portfolios:

• Quantitative long-only portfolios are constructed using systematic rules and risk controls.
• These portfolios focus on specific factors (such as value, momentum, or quality) to predict future returns.
• Notably, the long-only constraint naturally leads to high conviction portfolios, concentrating on a select set of nonzero positions.
• These portfolios share some similarities with discretionary stock pickers, despite their systematic approach.

Factor-Based Long-Only Strategies:

• Factor investing involves targeting specific characteristics (factors) that historically drive returns.
• For example, a?value factor portfolio?might go long on the top 30% of the cheapest stocks (based on metrics like price-to-book or price-to-earnings) and short the 30% most expensive stocks (the growth or glamour portfolio).
• Similarly, other factors like momentum, low volatility, and quality can be used in long-only strategies.

Equity Long-Only Hedge Funds:

• Equity long-only hedge funds primarily invest in rising assets.
• Unlike traditional hedge funds that use both long and short positions, long-only hedge funds focus solely on long positions.
• These funds have more flexibility and room for adjustments in their portfolios, aiming for improvement over time

Long-only funds typically seek alpha in specific areas, while traditional funds often benchmark against the market indices.

Short-only portfolios

• A?short-only portfolio?involves taking?short positions?in assets (such as stocks, currencies, or commodities).
• Investors sell borrowed assets with the intention of buying them back at a lower price.
• The goal is to profit from falling prices.

How It Works:

• Short Selling: Investors borrow and sell assets they don’t own (short selling).
• Price Declines: They hope the asset prices will decrease.
• Buying Back: Later, they buy back the assets at a lower price to return them to the lender.

Benefits of Short-Only Strategies:

• Risk Mitigation: Short positions act as a hedge against long positions. When markets decline, short positions can offset losses.
• Diversification: Integrating short positions enhances portfolio diversification.
• Profit Potential: If the asset prices fall significantly, short sellers profit.

Challenges and Risks:

• Unlimited Losses: Unlike long positions (where losses are capped), short positions have unlimited downside risk.
• Market Timing: Correctly timing short positions is crucial.
• Interest Costs: Borrowing fees and interest on borrowed assets add to costs.

Implementing Short-Only Strategies:

• Active Management: Investors actively select assets to short.
• Quantitative Models: Some use quantitative models to identify overvalued assets.
• Closed-End Funds: These funds often employ active short strategies

How profitable short-only portfolios

It is possible to have a short-only portfolio, although it is less common than long-only portfolios. A short-only portfolio consists entirely of short positions, where the investor sells securities they do not own with the expectation that the price will decline, allowing them to buy back the securities at a lower price and profit from the difference.

Investors who manage short-only portfolios typically have a bearish outlook on the market or on specific sectors or securities. They may use short-selling as a way to capitalize on perceived overvaluations or weaknesses within companies, industries, or the broader market.

Short-selling is a high-risk strategy since losses can be theoretically unlimited if the price of the shorted securities rises instead of falls. Therefore, short-only portfolios are usually managed by experienced investors or hedge funds that have strong risk management strategies in place to mitigate potential losses.

However, due to the risks involved and the potential for significant losses, short-only strategies are not as widely utilized as long-only strategies, which tend to align with the general upward trend of the market over time. Short-only strategies often require more active management and closer monitoring than long-only strategies.

How to manage risk in short-only portfolios

To manage risk in short-only portfolios is much more challenging than in long-only portfolios. However the main tolls are:

Diversification:

• Even in a short-only portfolio, diversification matters.
• Shorting a wide range of assets across different sectors can help mitigate specific risks associated with individual stocks.
• Avoid concentrating too much risk in a single short position.

Risk Assessment and Analysis:

• Continuously assess the risk of each short position.
• Understand the fundamental reasons behind the expected price decline.
• Monitor market news, company announcements, and industry trends.

Stop-Loss Orders:

• Set stop-loss orders for short positions.
• If the asset price rises beyond a predetermined level, the position will automatically be covered (bought back).
• This helps limit losses.

Risk Tolerance and Position Sizing:

• Determine your risk tolerance before entering short positions.
• Calculate the appropriate position size based on your risk tolerance and overall portfolio size.
• Avoid overly large positions that could lead to significant losses.

Hedging Strategies:

• Consider using options or other derivatives to hedge short positions.
• Protective put options can limit losses if the shorted asset’s price unexpectedly rises.

Research and Due Diligence:

• Thoroughly research the companies or assets you’re shorting.
• Understand their financial health, competitive landscape, and potential catalysts for price declines.

Market Timing:

• Timing short positions is critical.
• Avoid shorting during strong bull markets or when sentiment is overly positive.
• Look for technical indicators or fundamental signals that suggest weakness.

Transforming long-only portfolio into short-only portfolio

Transforming a?long-only portfolio?into a?short-only portfolio?within a year is feasible, although it requires careful planning and execution. Here are some approaches:

Conceptual Understanding:

• Recognize that a long-only active portfolio can be thought of as the sum of two components:A market-cap weighted index (representing the overall market exposure).The over- and underweight decisions made by the active manager (forming a dollar-neutral long/short portfolio).
• By shorting out the market-cap weighted index from the long-only active strategy, we obtain the long/short portfolio.

Implementation Options:

• Shorting S&P 500 Futures Contracts:If you have the opportunity, short S&P 500 futures contracts.This directly converts a long-only portfolio into a long/short one.
• Inverse ETFs:Hold a long position in an inverse ETF (e.g., ProShares Short S&P 500 ETF, ticker symbol “SH”).Note that capital is tied up in a position that effectively returns Treasury Bills minus the S&P 500.
• Leveraged Short ETFs:Use leveraged short ETFs (e.g., ProShares UltraShort Short S&P 500, ticker symbol “SDS”).Only half the necessary capital is tied up, but tracking error due to compounding effects may occur.

Example: Constructing a Long/Short Portfolio:

• Consider a momentum/low-volatility barbell: Use iShares Edge MSCI USA Momentum Factor ETF (“MTUM”) and iShares Edge USA Min Vol Factor ETF (“USMV”) for long factor positions. Hold a 50-50 barbell (47.5% in each ETF) and allocate 5% as collateral for a 95% short position in S&P 500 futures.
• Results are strong both before and after ETF launch

Summary

Transforming long-only portfolio into a short-only portfolio is possible. However, it is not advisable to have short-only portfolios due to unlimited risks of loss.

On the other hand, long-short equity strategies seek to minimize market exposure by profiting from both stock gains in the long positions and price declines in the short positions. This can potentially generate superior risk-adjusted returns or higher overall returns with less risk. Moreover, an integrated optimization of long and short positions has the potential to maximize the value of investors’ insights by taking advantage of profit opportunities from securities identified as both under-valued and over-valued.

The key benefit of long-short investing is adding diversification to a portfolio beyond what the market provides, thus helping to mitigate risk. However, while many real assets investment portfolios are long-only, incorporating short positions could potentially enhance a portfolio’s potential by eliminating the limitation of only profiting from market upswings.

In essence, both long-only and short-only portfolios have their respective importance, with long positions signifying a buying stance and short positions readying an investor to benefit from selling securities. Depending on the investment goals and risk tolerance of an investor, employing a combination of both strategies might be considered to balance potential returns against market volatility.

Research sources: “Portfolio Selection with Active Strategies: How Long Only Constraints Shape Convictions”, Charles-Albert Lehalle & Guillaume Simon.

“Market Neutral Investing: Long / Short Hedge Fund Strategies”, Joseph G. Nicholas.

“Modern Portfolio Management: Active Long/Short 130/30 Equity Strategies”, Martin L. Leibowitz,?Simon Emrich,?Anthony Bova.

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