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Here is an excerpt from E. Chan's book Quantitative Trading,

However, if the strategy is a long-short dollar-neutral strategy (i.e., the portfolio holds long and short positions with equal capital), then 10 percent is quite a good return, because then the benchmark of comparison is not the market index, but a riskless asset such as the yield of the three-month U.S. Treasury bill (which at the time of this writing is about 4 percent).

I do not understand why a long-short strategy is riskless - AFAIK in a short-long position with equal dollar amount in each, the short would pay for the long, but how does that translate into risklessness?

Thanks,

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  • $\begingroup$ Notice that he didn't quite say that a long-short strategy is riskless, that was your inference. He is just saying that he is going to use the riskless t-bills as a benchmark. For example in the CAPM stocks with a zero beta earn $R_f$ but they are not riskless. $\endgroup$ – noob2 Feb 9 '16 at 17:52
  • $\begingroup$ @noob2 yes. Long-short strategy is not completely riskless. They still exposed to idiosyncratic risk. But such risk can be eliminated by creating diversified portfolio. $\endgroup$ – Neeraj Feb 9 '16 at 18:55
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Long-short strategy is generally used by hedge funds. In simple words, an equity long-short strategy means buying an undervalued stock and selling(shorting) an overvalued stock. In normal circumstances, the long position will increase in value and the short position will decline in value. In this situation, the hedge fund will benefit. This strategy would work even if the long position declines in value but provided that the long position outperforms the short position.

Thus, the goal of any equity long-short strategy is to minimize market exposure, and get profit from a change in the difference between two stocks.

Let's take a simple example. A hedge fund takes a \$10 million long position in General Motors and a \$10 million short position in Volkswagen, both large automobile companies. With these positions, any event that causes all automobile stocks to fall will lead to a loss on the General Motors position and a profit on the Volkswagen position. Similarly, an event that causes both stocks to rise will have little effect, since the positions balance each other out. So, the market risk is minimal. But question arise, Why would a portfolio manager take such a position? Because he or she thinks General Motors will perform better than Volkswagen.

Equity long-short strategies which hold equal dollar amounts of long and short positions, are called market neutral strategies or long-short dollar neutral strategy (as described above).

Since, portfolio is immune to both upside and downside market risk, like risk free security, its performance must be measure from similar security ie riskless assets such as U.S. Treasury bill etc.


You can read more about market neutral strategy from here.

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    $\begingroup$ FYI.. Dollar neutrality is not the same thing as market neutrality $\endgroup$ – silencer Feb 10 '16 at 2:40
  • $\begingroup$ @silencer you are welcome to write your own answer. We all here to learn from each other. I would definitely appreciate your answer if you could define what is difference between market neutrality and dollar neutrality. It would also help the other users to gain more insight into the subject matter. $\endgroup$ – Neeraj Feb 10 '16 at 15:48
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They are not riskless and a TBill is not the right benchmark comparison. While a dollar neutral long/short portfolio does provide enhanced risk management, the extent is dependant upon the composition of the portfolio. For example, if long 10M IBM and short 10M XOM, what have you hedged ? What is the relationship between IBM and XOM ?

In this example you are hedging broad market (Beta) changes but nothing specfic to the sector or stocks.

For a benchmark you cannot use the TBill. For this imaginary portfolio to fail, all that is needed is bad news from IBM (or technology sector) and Oil issues (oversupply anyone ?). My point is that long/short does reduce risk and is a great strategy but you have to understand the portfolio to understand its risks.

To see how Long/Short hedge funds are performing overall, look at the Barclay Equity Long/Short Index (www.barclayhedge.com/research/indices/ghs/Equity_Long_Short_Index.html)

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