Equity Portfolio Strategies Atilim Murat TOBB ETU MBA May 20, 2010

Equity Portfolio Strategies

Atilim MuratTOBB ETU MBAMay 20, 2010

Sources of return and feasible portfolios

• Traditional long only equity strategies have only one source of return,that is the appreciation of the stock purchased

• Long/short strategies,in contrast, have four potential sources of return

• The first source is the spread in performance between the long and the short postions(long/short investing is often referred to as a double alpha strategy)

Sources of return and feasible portfolios

• The 2nd source of return is the interest rebate on the proceeds of the short sale that are used as collateral. The lending fee is taken

• The 3rd source of return is the interest paid on the liquidity buffer that remains as a margin deposit to the broker(T-bill rate)

• The 4th source is the spread in dividends between the long and the short position

The case of long/short equity(equity hedge) investing

• Consider a hedge fund that has an equity capital of $1000

• Hedge fund thinks stock A is undervalued, stock B is overvalued

• Long/short strategy to profit• First, the fund manager deposits the $1000 at a

prime broker• Second, buying $900 worth of stock A(long

position in stock A for $900,long cash position of $100

The case of long/short equity investing

• Hedge fund now sells $800 worth of stock B• This increases his cash balance by $800• Fund does not own any B shares, this is a

short sale• Borrow shares from a third party• The prime broker arranges to borrow $800

worth of required shares from a stock lending institution(say institutional investor)


• The prime broker freezes some collateral to secure the transaction

• Prime broker gets the $800 that the fund just cashed in,plus some stock A shares fund has previously bought

• Charges the hedge fund a rent, say 1% for one year ($8 at the end of the lending period if the short position is maintained for a year)


• Fund is using leverage• Assets:$900 of stock A (long) $800 of stock B (short) $900 in cash =$2600 of assets(initial equity capital was

$1000)• Fund has a %90 long exposure, an %80 short

exposure(%170 gross exposure)• 10%(90-80)= net long exposure


• If the value of the collateral falls or if the shorted stock (B) price increases, the fund will receive a margin call to put more collateral

• Ability to sell short• Good prime broker • Buy $900 of stock A and sell $900 of stock B,it

is a dollar neutral position(zero net exposure)

Portfolio Efficiency

• Long-only equity strategies have only one source of return

• Long-short strategies you have more than one source of return

• Let’s say stock A share price up from $10 to $11(plus a $1 dividend)

• Stock A is 20% up• Profit 20%*$900=$180 on the long position


• Also stock B(it was a short position),increases from $10 to $10.25 and pays in addition a $0.25 dividend at the end of the month

• 5% increase in total, loss of (5%*$800) = $40 on the short position

• The interest paid on the short proceeds are 6% p.a., a gain of (0.5%*800) = $4 over a month

• Unused capital of $100 could be invested at 6%p.a. which gives (0.5%*$100) = $0.5 of interest


• If the fee to borrow the shares is 1% p.a.,the cost over 1 month will be (1%/12)*800= $0.66

• Change in A shares + $180• Change in B shares - $40• Int. on short proceeds + $4• Int. on unused capital + $0.50• Renting fees - $0.66• Total profit = +143.84


• Initial capital was $1000, the total return is therefore 14.38%

• Position is still profitable• Long only portfolio invested in 50-50 in shares

A and B would have achieved a return of approximately 12.50% (very close to 14.38%)

• Why dealing with these?


• Fund manager was wrong on the short side, let’s say stock B is down 5%

• Change in A shares(with dividends) +$180• Change in B shares +$40• Int. on collateral +$4• Int. on unused capital +$0.50• Renting fees -0.66• Total profit $223.84• 22.38% profit versus approximately 7.5% for 50-50 portfolio(equally weighted)


• Diversification benefit(long/short portfolio has a much lower risk than the long only position)

• It reduces portfolio risk• There is a good chance that securities A and B are

positively correlated(limited diversification)• The correlation between the short and long will be negative• Long-short funds take positions in highly correlated

securities to diversify risk• Long only funds take positions on non-correlated securities

Case: Peugeot Versus Renault

• Year 2001• Peugeot reported a net profit for 2001 of 1.7

billion euros (29% up on the year before)• Renault reported a 77% decline in profits,

blaming the economic crises in Argentina and Turkey

• Realized return on the Peugeot stock was 3.2% with a volatility of 33.2%

Case: Peugeot versus Renault

• Realized return on the Renault stock was -41.7% with a volatility of 38.5%• The correlation between the two stocks was

0.4• Long Peugeot-Long Renault strategy(50 long

Peugeot-50 long Renault= -19% return, 30% volatility


• Long Peugeot-Short Renault strategy(assume any cash be invested at 4.5% p.a. and that borrowing Renault shares costs -0.375% p.a.)

• Deciding to go short Renault creates a new asset with a positive return(45.825%=41.7%+4.5%-0.375%

• …and a volatility of 38.5%, and a negative correlation with the long Peugeot position -0.4


• Much more attractive than the original long Renault position(better in terms of portfolio construction)

• Long-short strategy provides a much better risk/return trade-off, mostly because of the negative correlation between the long and the short position

• … but also because of the higher return of the short Renault position

Case: Peugeot versus Renaul

• Stock-picking skills and used them to identify Renault as a short and Peugeot as a long.

• What would happen if the fund manager had made the wrong bet(sold short Peugeot and bought Renault)?

• -15% return, 19% volatility• Much worse than previous long/short• … but still performs better than the long-only

strategy


• For long-short equity strategy; to reduce the consequences of a possible wrong stock selection, diversify your portfolios, both on the long and the short side

• Concentration limits that fix the max size that a position could grow to(5% of the total portfolio)

Pros of Short Selling

• In contrast to the huge amount of undervalued companies, short selling opportunities is largely unexploited

• Asset management firms searching for long term buy and hold opportunities rather than good short sales

• Individual investors cannot understand the mechanism of short selling

• Institutional investors cannot or do not want to sell short

Pros of Short Selling

• Investment banks’ analysts generally don’t issue a negative recommendation on a company

• It would be harder for the analysts to maintain a good relationship with the company

• The good news is more widely known and got into stock prices than bad news

• Ideal free lunch for short sellers

Cons of Short-Selling

• In the LR, stocks tend to appreciate in price and reward investors with a positive equity risk premium

• The long-only investor will benefit from the equity risk premium and regularly receive dividend payments

• Short-side, the story is quite different• They are hit by the natural tendency of appreciation• They must pay the dividends on the shorted stocks

to their lenders

Cons of Short Selling

• Short sellers dealing with illiquid, small companies

• Take the risk of snowball buying• Ending up in a short squeeze• As prices go up, more and more short sellers

will have to buy back shares• Stock price will continue to rise

Potential Short-Sale Targets

• Companies with weak financials but a high share price

• Excessive amount of leverage• Companies which regularly change their

auditors or regularly delay filing their financial reports to regulatory arm(SPK,SEC)

• Involved in industries where there is overcapacity, have earnings shortfalls

Potential Short-Sale Targets

• Companies whose P/E ratios are much higher than can be proved by their growth rates

• Companies that have been involved in a failed merger

• Companies with a potential public image problem

• Companies that claim to discover new reserves of natural resources

Documents

Equity Portfolio Strategies Atilim Murat TOBB ETU MBA May 20, 2010