Equitizing a Market-Neutral Long-Short Portfolio

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Bankin

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I’m probably missing something obvious, but I don’t understand this LOS.
LOS 33.n says “Explain how a market-neutral portfolio can be “equitized” to gain equity market exposure and compare and contrast equitized market-neutral portfolios with short extension portfolios.
It is my understanding that a market-neutral long short strategy is essentially a pair-trade, i.e. shorting AT&T and going long Verizon, or something like that (that’s my example, not the book’s).
It says “a market-neutral portfolio can be equitized by taking a long position in an equity futures contract with a notional principal equal to the cash from the short sales.”
Now they’ve lost me… What short sales? Do I short something else? If so, what? More AT&T? An ETF of a different market index? If the former, then it seems my short position in a single security exposes me to excessive unsystematic risk, if the latter than how is the position equitized?
Do I get out of Verizon and put those funds in equity futures contracts? This seems totally wrong, because now if the Telecom sector goes through the roof, but the market just trudges along then I’m in trouble.
Any help would be appreciated.
 
Short sales indicates selling a position you don’t own. Most institutions have to borrow the security in order to sell it short. If you don’t borrow the security, then it is considered to be naked short selling.
OK, technically a market neutral portfolio has a beta of zero. Utilizing your AT&T and Verizon example.. Shorting AT&T and going Long Verizon would mean you are expecting AT&T to tank and Verizon to shoot up.. hence a pairs trade. Why is this market neutral? Because you are offsetting the systematic risk.
Formula = alpha (Verison) + beta (telecom sector) - [alpha (AT&T) + beta (telecom sector)]
(where you expect AT&T to tank so subtracting a negative alpha would equal a positive ret)
*here I denote alpha as return due to firm specific risk
To gain equity market exposure, you would “overlay” this by going long (or in other words, purchasing) market exposure by buying index futures.
hope this helps
 
sha_carsie,
Thank you for your response. You said “To gain equity market exposure, you would “overlay” this by going long (or in other words, purchasing) market exposure by buying index futures.” Prior to doing this I don’t need to short anything else? I just add cash to my original position, is that correct?
 
Because you are shorting verizon and buying ATT, you are using your cash to buy ATT but you are also generating cash by shorting verizon. To gain equity exposure, you are simply using the cash the you got from shorting verizon and buying equity futures to get some systematic risk.
One thing I’m not clear on is why you would want systematic risk at all in a market neutral strategy. Anyone?
 
Smarshy Wrote:
——————————————————-
> Because you are shorting verizon and buying ATT,
> you are using your cash to buy ATT but you are
> also generating cash by shorting verizon. To gain
> equity exposure, you are simply using the cash the
> you got from shorting verizon and buying equity
> futures to get some systematic risk.
>
> One thing I’m not clear on is why you would want
> systematic risk at all in a market neutral
> strategy. Anyone?
Thank you for your response.
So what you’re saying is:
Time Period ——- Portfolio
T0 = $1MM Cash
Enter Pair Trade
T1 = Purchase $1MM in Verizon stock (with my cash), short $1MM in AT&T stock and put the cash from the short sale in treasuries or something.
Equitize position
T2 = Take $1MM out of treasuries and put it into futures contracts on the S&P 500 or some other index
Is that correct?
I don’t have my books in with me so I can’t look it up, but it seems like you would want systematic risk because you think the market as a whole will rise. In the initial positon if the market as a whole moved up 10% and both AT&T and Verizon basically moved with the market your positions would net to nearly zero. If however you ‘equitized’ your position because you thought that the market as a whole would move up, your pair trade would net to nearly zero but your equity futures position would pay off.
 
I can no longer edit my previous post, but it just occurred to me that my original logic was flawed because the short positon requires margin so in actuality you can’t just short AT&T (without putting up cash) and use the cash from the short sale to purchase verizon. Thank you sha_carsie and smarshy for your assistance in reconciling this for me.
 
Bankin’ - Have you done your little T accounts (well whatever you call them, that’s just what I think of them as) in the commodities futures section. You know.. the whole section with the pencil having a lease rate… blah blah blah… Well if you work through the cashflow, the curriculum assumes that your receive cash (or that your account is credited) on the day you short the security. You’ll see what I mean.
 
sha_carsie Wrote:
——————————————————-
> Bankin’ - Have you done your little T accounts
> (well whatever you call them, that’s just what I
> think of them as) in the commodities futures
> section. You know.. the whole section with the
> pencil having a lease rate… blah blah blah…
> Well if you work through the cashflow, the
> curriculum assumes that your receive cash (or that
> your account is credited) on the day you short the
> security. You’ll see what I mean.
I’ve completed SS 3 - 11 and am about 1/4 of the way through SS 12 Hopefully it’s in a future Study Session, because I didn’t retain it if it was in a SS that I covered.
 
I’m still not clear on why you would equitize a market neutral strategy. Isn’t the whole point to stip away the systematic risk?
 
Well okay back to the example right
Short Verizon
Long AT&T
If you expect the market to rise, then your beta gains will offset each other and the spread between the two will still remain constant.
Formula = (-Verizon Alpha -Telecom Beta) + (+AT&T Alpha + Telecom Beta)
The Beta’s net out so you have a simplified version of
Formula = -Verizon Alpha + AT&T Alpha
The market movement of +10% or -10% will have (theoretically) no effect because it is a pair trade. All you are worried about is the spread divergence. Hence, the equitization arguement above does not make sense in this context. A pair trade is an event driven strategy.
Even if we are not working with a pair trade strategy, the beta is still neutralized so any market movements are moot. Mooooot! Do not pass go… which still leaves us with this puzzle???
 
ValueAddict Wrote:
——————————————————-
> Well okay back to the example right
>
> Short Verizon
> Long AT&T
>
> If you expect the market to rise, then your beta
> gains will offset each other and the spread
> between the two will still remain constant.
>
> Formula = (-Verizon Alpha -Telecom Beta) + (+AT&T
> Alpha + Telecom Beta)
>
> The Beta’s net out so you have a simplified
> version of
>
> Formula = -Verizon Alpha + AT&T Alpha
>
> The market movement of +10% or -10% will have
> (theoretically) no effect because it is a pair
> trade. All you are worried about is the spread
> divergence. Hence, the equitization arguement
> above does not make sense in this context. A pair
> trade is an event driven strategy.
>
> Even if we are not working with a pair trade
> strategy, the beta is still neutralized so any
> market movements are moot. Mooooot! Do not pass
> go… which still leaves us with this puzzle???
I agree with everything you said up until “Hence, the equitization arguement above does not make sense in this context. A pair trade is an event driven strategy.”
Your formula is correct for an unequitized pair trade, but once you equitize it in addition to = -Verizon Alpha + AT&T Alpha you are also getting the Beta from the underlying equity index and possibly interest of any proceeds of the short sale not tied up in equities.
So if you’ve entered a pair trade you’ve already placed a bet that the Alpha on Verizon will outperform the Alpha on AT&T. Then if you equitize your position you also earn the market rate of return on the portion that was equitized.
Smarshy Wrote:
——————————————————-
> I’m still not clear on why you would equitize a
> market neutral strategy. Isn’t the whole point to
> stip away the systematic risk?
Why do this? Perhaps you think that Verizon will outperform AT&T and you want those positions to offset each other, but you also think that the market will go up so you want exposure to an index.
 
Not following. Lets say you think that the pair trade worked out - its run its course - now you cover the short and sell the long.
But you can get market exposure without realizing any gains/losses on the pair trade. Since you have $100 originally lets say. If you have a pair you are close to having the original $100 since you can buy the long with the proceeds of the short (less margin). So its an independent decision.
I can have the trade on and still get market exposure if I wanted to.
 
ValueAddict Wrote:
——————————————————-
> Not following. Lets say you think that the pair
> trade worked out - its run its course - now you
> cover the short and sell the long.
>
> But you can get market exposure without realizing
> any gains/losses on the pair trade. Since you
> have $100 originally lets say. If you have a pair
> you are close to having the original $100 since
> you can buy the long with the proceeds of the
> short (less margin). So its an independent
> decision.
>
> I can have the trade on and still get market
> exposure if I wanted to.
I actually think we’re saying the same thing, but it’s been a long week so let me type it out to be sure.
My understanding of the reason you’d want to ‘equitize’ your pair trade is because you think Verizon will outperform AT&T AND you want market risk exposure in order to (hopefully) earn a higher return.
You don’t think that the pair trade has run it’s course, you just want market risk exposure as well.
T0: $1MM cash
T1: Short $1MM of AT&T
Now have $2MM cash
Long $1MM of Verizon
At T1 we just have a pair trade and we have $1MM in cash. Our goal now is to equitize the pair-trade.
“Reading 33 LOS n. explain how a market-neutral portfolio can be “equitized” to gain equity market exposure”
T2: Put $1MM in an equity futures contract.
We’re done, we’ve equalized our position. I suppose we could use margin and put more money in, but I think the example above illustrates what the LOS asked for.
To address Smarshy’s question it seems like the reason you would do this is because you want market risk exposure and you think that Verizon will outperform AT&T.
Does that make sense?
 
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