Transcript Fixed Income and Equity Strategies

Equity Portfolio Strategies
Atilim Murat
TOBB ETU MBA
May 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 case of long/short equity investing
• 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)
The case of long/short equity investing
• 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
The case of long/short equity investing
• 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
Portfolio Efficiency
• 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
Portfolio Efficiency
• 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
Portfolio Efficiency
• 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?
Portfolio Efficiency
• 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)
Portfolio Efficiency
• 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
Case: Peugeot versus Renault
• 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
Case: Peugeot versus Renault
• 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
Case: Peugeot versus Renault
• 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