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Equity Portfolio Strategies Atilim Murat TOBB ETU MBA May 20, 2010
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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)
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Sources of return and feasible portfolios The 2 nd 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 3 rd source of return is the interest paid on the liquidity buffer that remains as a margin deposit to the broker(T-bill rate) The 4 th source is the spread in dividends between the long and the short position
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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
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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)
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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)
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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
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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)
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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
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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
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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
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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?
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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)
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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
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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%
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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
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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
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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
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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
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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)
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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
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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
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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
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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
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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
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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
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