Long only strategy and its constraints (Bota)

It is a general thought that investors feel more comfortable in employing long only strategies. However, many academic studies have shown that information efficiency of long only portfolio can be significantly improved by practicing short selling.

Clarke et al. (2004), demonstrate that long only approach is the most important constraint regarding the information loss. They argue that many advantages can be obtained by relaxing the long positions with even modest proportion of short positions. In their research they created so called "fully constrained portfolio" with annualized standard deviation between portfolio's return and return of S&P 500 used as a benchmark of 4%. The portfolio included all significant constraints according to the authors: holding balanced proportion of large and small cap stocks in the portfolio, industry and sector neutrality, and no short selling.

Methodology used by authors is based on Clarke at al. (2002) expanded Fundamental Law i.e. information ratio (IR) depends not only by the information coefficient (IC) but also by the transfer coefficient (TC) i.e. the extent to which IC is transferred into portfolio's active weights. In this direction, the impact of each constraint is measured with documenting the changes in the portfolio's TC by removing constraints one by one.

The results from the study showed that fully constrained portfolio have TC of 0.332 and by allowing short selling TC increased by 108%. Furthermore, results showed that market capitalization neutrality constraint also have significant impact regarding information loss as by removing this constraint TC increased by 46%.

Clarke et al. (2004) argue that portfolios activities could be increased by allowing managers to use short selling. Also, modestly 20% of shortening can significantly boost up the TC compared to the long only approach. Likewise, for more conservative investors, shortening provides them an opportunity to employ investment strategy without using the derivatives (put options, swaps, spread beats or stock futures). However, authors note that the trade-offs exist between the range of shortening, tracking error and TC, as all of them cannot be controlled at once.

Some might argue that short selling is hazardous and contributes towards market destabilization. After the credit crunch, regulators applied many restrictions to the short selling such as expanding the list of shared banned for shorting. On the other hand, many academic studies showed that markets are mostly efficient when short selling is employed.

According to Boehmer et al. (2009) short sellers are often those who are unreasonable blamed in sharp fall of share prices. In their study they compared banned and non banned stocks in order to identify the effects of various levels of short selling and changes in price. Banding more than 1000 of stocks for short selling by the US Security and Exchange Commission (SEC) resulted in decreasing the short selling activities by 65%. However, this action did not contribute to the more market quality. In addition, by analyzing the change in prices of stock added to the ban list, they found that stocks were underperforming continuously even in the period when the ban was enforced. Results revealed that applying shorting restriction does not lead to a synthetic increase in stock prices.

Saffi and Sigguardsson (2010) studied the relation between stock price efficiency and short selling using a global data sample of over 12,600 stocks for the period between 2005 and 2008. The results from their empirical study are in support of the short selling investment strategy. More concrete, they found that stocks with short selling restrictions are less price efficient compared to the stocks allowed for short selling. Also, they showed that short selling does not contribute to the negative returns or price instability.

Boehmer et al. (2008) conclude that short selling is present with significant proportion of 12.9% of the total trading volume at the New York Stock Exchange in the period between 2000 and 2004 and that compared to the average market participants, short sellers are well informed.

Having in mind aforesaid limits of the long only approach and well documented benefits of short selling, our investment strategy aims toward investors who do not feel comfortable in using derivatives but yet are willing in achieving higher returns than those offered by long only portfolios. We believe that short selling is the best alternative for the complex financial products.


References:

Ekkehart Boehmer, Charls M. Jones, Xiaoyan Zhang, "Which shorts are informed?", The Journal of Finanace, vol.63, no.2, 2008

Ekkehart Boehmer, Charls M. Jones, Xiaoyan Zhang, "Shackling Short Sellers: The 2008 Shorting Ban", 2009, Working paper available at: http://ssrn.com/abstract=1412844

Pedro A.C. Saffi, Kari Sigurdsson, "Price Efficiency and Short Selling", 2010, Working paper available at http://ssrn.com/abstract=949027

Roger G. Clarke, Harinda de Silva, Stiven Sapra "Toward More Information-Efficient Portfolios", Journal of Portfolio Management, Fall 2004, 54-63;

Roger G. Clarke, Harinda de Silva, Stiven Thorley "Portfolio Constraints and the Fundamental Law of Active Management", Financial Analyst Journal, vol.58, no.5, September/October, 2002, pp.48-66;

Source: Essay UK - http://turkiyegoz.com/free-essays/finance/long-only-strategy-and-its-constraints.php


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