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Let's say I've developed a strategy that always outperforms the S&P-500, let call it the "magic strategy".

Now I should be golden. All I need is to always have the S&P shorted with the same amount as I have in the magic strategy, and my outcome is bound to be positive.

But how much better does my strategy have to be? Let's say that while the S&P returns 10% per year and my strategy returns 11% in the same period, then my set-up return would look like this:

  • 50% of my money invested in S&P shorts becomes 45.45% of the starting value
  • 50% of my money in the Magic Strategy becomes 55.5% of the starting value

making my collected results 1%.

In a world where everything is free, I could just leverage this 1:99 and the result would be 100%, not bad?

But what would be the cost of this sort of strategy in the real world? How much do I have to outperform something in order to make a "A outperforms B" sort of bet?

When I read papers they often show how this or that approach, outperforms some index -- how much do you need to outperform something to be able to make a hedged bet?

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    $\begingroup$ What does leverage cost? This is something you need to ask your broker. $\endgroup$
    – chrisaycock
    Mar 14, 2012 at 12:38
  • $\begingroup$ @chrisaycock: you are absolutely right! But perhaps my question is to be understood more like -- how much should one expect leverage to cost? $\endgroup$
    – Martin Kristiansen
    Mar 14, 2012 at 12:40
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    $\begingroup$ I'm not shure I understand the question, because the obvious answer would be that it would cost the interest on the loan you would have to take out. I think the spread you would have to pay depends on the collateral that you were able to pledge. $\endgroup$
    – Owe Jessen
    Mar 14, 2012 at 12:59
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    $\begingroup$ The practical haircut taken by industry players is generally greater than any theoretical haircut. So, for example, if your loan costs are 1%, no one will be interested in a strategy that beats SP by 1.5%. It starts to become a matter of taste, and in my experience the ones allocating the money ultimately rest the decision on their instincts more than anything else. $\endgroup$
    – Brian B
    Mar 14, 2012 at 13:41

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cost of leverage for equity only long/short investing is a function of the margin deal you can negotiate with your broker, if you have a large amount of capital.

If you don't have significant capital to start with, then it's likely you'll only be able to get 2x leverage with a loan rate between 4% and 10% (retail reg-t margin rates at most brokers)

This would render your strategy unprofitable, since you'd be paying 2% to 5% loan for a portfolio that only generates 2% return.

You might get more traction by restating the question as: Assuming a margin rate of X% with a leverage ratio of Y times capital, how much does a strategy have to out perform a hedge portfolio to earn a positive return.
(simpler to estimate)

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