Questions and Answers About Market Neutral Investing 13
lio from long and short positions rather than achieving neutrality via a
derivatives contract based on an underlying index.
Jacobs: This reflects the fact that long-only portfolios are generally con-
strained by the weights of the names in the underlying index, whereas
market neutral long-short portfolios, if properly constructed, are free of
index weights. This is most noticeable when you look at stock under-
weights. Given that the market capitalization for the median stock in the
U.S. equity universe is 0.01% of the market’s capitalization, a portfolio
that cannot short can achieve, at most, a 0.01% underweight in the aver-
age stock; this underweight is obtained by excluding the stock from the
portfolio. The manager may have a very negative view of the company,
but the portfolio’s ability to reflect that insight is extremely limited. The
manager that can sell short, however, can underweight this stock by as
much as investment insights (and risk considerations) dictate.
Levy: It’s important to note that the market neutral long-short portfolio
also has greater leeway to overweight stocks, because the manager can
use offsetting long and short positions to control portfolio risk. Whereas
a long-only portfolio may have to limit the size of the position it takes in
any one stock or stock sector, in order to control the portfolio’s risk rela-
tive to the underlying benchmark index, the market neutral long-short
portfolio manager is not circumscribed by having to converge to bench-
mark weights to control risk. The freedom from benchmark constraints
gives market neutral long-short portfolios greater leeway in the pursuit
of return and control of risk—a benefit that translates into an advantage
over market neutral portfolios constructed without shorting.
Can I “neutralize” my long-only portfolio by adding a short-only
portfolio?
Buchan: Yes, but you would miss out on the real benefits of market neu-
tral portfolio construction—the added flexibility to pursue returns and
control risks that comes from the ability to offset the risk/return profiles

of individual securities held long and sold short.
Levy: Integrated portfolio optimization results in a single market neutral
portfolio, not a separate long portfolio plus a separate short portfolio.
But a long portfolio combined with a short portfolio would be
market neutral?
Jacobs: Yes, but it would offer little advantage over a long-only portfo-
lio that achieved neutrality via derivatives positions.

c02.frm Page 13 Thursday, January 13, 2005 12:12 PM
14 MARKET NEUTRAL STRATEGIES
Wouldn’t it benefit from the diversification provided by a less-
than-one correlation between the returns on the long positions
and the returns on the short positions?
Levy: But the same benefit can be achieved by adding to a long-only
portfolio a less than perfectly correlated asset with similar risk and
return. The unique advantages of market neutral long-short portfolios
come only from an integrated optimization.
Will my portfolio be market neutral if I have equal amounts
invested long and short?
Levy: Not unless the sensitivities of the positions held long and sold
short are also equivalent. If the amounts invested are equal, but the
betas are not, the portfolio will incur market risk (and returns). An
investor might want to place a bet on the market’s direction by holding
larger and/or higher-beta positions long than short if the market is
expected to rise, or vice versa if the market is expected to decline, but
the portfolio in that case is not market neutral.
Buchan: It is also important to note that even a beta-neutral portfolio
can retain residual exposures to certain market sectors. For example,
long positions may overweight the technology sector, relative to the
short positions, resulting in a portfolio that is exposed to systematic risk

in this sector. A well-designed beta-neutral portfolio, however, will have
such exposures only as the result of a deliberate choice on the part of
the investor.
Jacobs: A similar problem arises in fixed-income market neutral. Mar-
ket neutral fixed-income portfolios are generally designed to have
matching durations for the longs and shorts; this means that, for a given
parallel change in interest rates, price changes in the long and short
positions will offset each other. If the term structure of interest rates
does not change in a parallel fashion, however (for example, if long
rates change less than short rates), price changes in the long and short
positions will not be offsetting. It is thus important to determine the
portfolio’s expected responses to movements in each part of the yield
curve (the short rate, the 10-year rate) and in each sector (corporates,
mortgages, etc.).
Aren’t short positions risky, or at least riskier than
long positions?
Levy: It’s true that the exposure of a long position is limited, because
the security’s price can go to zero but not below. Theoretically, a short

c02.frm Page 14 Thursday, January 13, 2005 12:12 PM
Questions and Answers About Market Neutral Investing 15
position has unlimited exposure because the security’s price can rise
without bound. In practice, however, this risk is considerably mitigated.
First, the short positions will be diversified across many securities. Sec-
ond, a substantial (undesirable) increase in the price of a security that
has been shorted will in all likelihood be at least partially offset by a
(desirable) increase in the price of correlated securities held long. Third,
because long and short positions must be kept roughly balanced to
maintain neutrality, shorts are generally covered as they rise in price,
limiting potential losses.

If you’re using short positions to create a market neutral
strategy, doesn’t that mean the strategy must be leveraged?
Jacobs: Not necessarily. The amount of leverage of a given strategy is
within the investor’s control. Although Federal Reserve Board Regula-
tion T permits leverage of up to two-to-one for equity strategies, for
example, the investor can choose not to lever. Thus, given an initial $100
in capital, the investor could invest $50 long and sell short $50; the
amount at risk is then identical to that of a $100 long-only investment.
Then wouldn’t you want to avoid leverage in order to avoid the
risk it entails?
Buchan: Actually, some leveraged market neutral strategies may be
much less risky than unleveraged long-only strategies. For example,
shorting a Treasury bond futures contract and owning the bond that is
deliverable against the futures contract at expiration is a much less risky
strategy than a long-only small-cap equity strategy. Furthermore,
restricting the choice of market neutral strategies to those that are
unleveraged can produce a “leverage paradox,” whereby, in order to
achieve a desired return, one may end up choosing an unleveraged strat-
egy that is inherently riskier than a strategy that could be “levered up”
to produce the same return at less risk.
Jacobs: In addition, by using all the strategies out there at the appropri-
ate leverage levels (which for some may be no leverage), you can take
advantage of the typically low correlations among all the strategies,
rather than just a subset. This will produce the least risky portfolio of
strategies, as you have the opportunity to diversify risks across many
different markets.
Levy: Furthermore, long-only portfolios can use leverage, too. However,
long-only strategies that borrow to leverage up returns expose the other-
wise tax-free investor to a possible tax liability, as gains on borrowed


c02.frm Page 15 Thursday, January 13, 2005 12:12 PM
16 MARKET NEUTRAL STRATEGIES
funds are taxable as unrelated business taxable income. Borrowing stock
to initiate short sales does not constitute debt financing, so profits result-
ing from closing out a short position do not give rise to unrelated business
taxable income (UBTI).
Buchan: In general, when judging any market neutral strategy, the ques-
tion should be whether the level of leverage is prudent with respect to
the strategy. Clearly, if the strategy involves buying Asian technology
stocks and shorting European financial stocks, there is a significant
amount of risk (so much, in fact, that few investors would consider such
a strategy market neutral). Conversely, if the strategy involves buying
stock in a company and then shorting the same company’s American
Depositary Receipt (ADR) against the long position, the risk would be
relatively small.
Jacobs: The same is true for fixed-income arbitrage: The level of prudent
leverage is dependent upon the strategy. Buying Japanese government
bonds and shorting European corporate securities is very risky; not only
are the corporates inherently riskier (and less liquid), but you’re arbi-
traging between two very different interest rate regimes. But buying U.S.
Treasuries and selling short Eurodollar futures (buying a so-called TED
spread), is not, as a trade, very risky.
Buchan: Basically, it’s not the leverage per se that matters, but rather the
leverage times the risk of the underlying position; or, more succinctly,
it’s the net exposure that matters.
So some market neutral strategies are riskier than others?
Buchan: Clearly, but this is true of investment strategies in general. With
market neutral, the riskiness depends to a large extent on the underlying
instruments. Mortgage securities, for example, are commonly perceived as
quite a bit riskier than government bonds. Even here, however, it is difficult

to generalize. Mortgage securities cover a wide range, from highly liquid
pass-throughs to unique tranches of collateralized mortgage obligation
(CMO) deals; therefore, it is misleading to lump all the different types of
mortgage securities in the same group. Many mortgage securities are
exposed to liquidity risk and prepayment risk (or, in more formal terms,
exhibit negative convexity), and may be difficult to value. But some famil-
iarity with these securities reveals that they are not that different from other
types of bonds. Take the prepayment risk: as individuals prepay their mort-
gages, pass-through securities exhibit negative convexity; when interest
rates fall, they increase in value by less than a similar fixed-rate government

c02.frm Page 16 Thursday, January 13, 2005 12:12 PM
Questions and Answers About Market Neutral Investing 17
security and, conversely, when interest rates rise, they fall by more than the
similar government security. But the investor is compensated for these
adverse outcomes with a higher yield. Thus, the salient question for the
pass-through investor is whether the yield on the security adequately com-
pensates for the adverse price risk.
Levy: This is essentially no different from ordinary government bonds.
Zero-coupon bonds, for example, have lots of positive convexity, on a
relative basis, and will therefore often yield less than coupon bonds.
There are also liquidity and valuation issues, just as with corporate
bonds. Most corporate bonds are illiquid, in the sense that it can cost a
lot to trade them. By this measure, many mortgage securities are actu-
ally more liquid than corporates. In addition, in valuing a corporate
bond, one has to estimate the probability of default and the correspond-
ing likely recovery rates—just as one has to estimate future mortgage
prepayment rates under differing economic scenarios.
Buchan: So mortgage securities are different from but, in general, not
necessarily riskier than other bonds used in market neutral strategies.

Jacobs: Ken’s comment about the liquidity of corporates reminds me
that one should also take into account, when evaluating the risk of a
particular strategy, the liquidity of the underlying markets, which may
be of critical importance especially for highly leveraged strategies. And
another concern I might add is the availability of opportunities in a par-
ticular strategy; to the extent that this may limit the ability to diversify
one’s portfolio, it can have a considerable impact on risk.
Aren’t market neutral strategies best exploited only in certain
situations or by investors with special information?
Jacobs: I’ve heard it said that market neutral equity strategies only make
sense if pricing inefficiencies are larger or more frequent for potential
short positions (that is, among stocks that tend to be overpriced) than
for potential long positions (stocks that tend to be underpriced). But
greater inefficiency of short positions is not a necessary condition for
market neutral investing to offer benefits compared with long-only
investing. These benefits reflect the added leeway to pursue return and
the greater control of risk that derive from the strategy’s freedom from
benchmark weight constraints.
Levy: It’s also frequently heard that merger arbitrage does not work
unless it’s based on insider information. But, as it is practiced in the

c02.frm Page 17 Thursday, January 13, 2005 12:12 PM
18 MARKET NEUTRAL STRATEGIES
institutional investment community, merger arbitrage is usually based
on a public announcement, where the identity of the target, the identity
of the buyer, and the rough terms of the transaction are disclosed. Even
after such an announcement is made, a spread between the acquirer and
the target tends to persist until the deal closes. This spread reflects the
very real risks that the deal will not close or, if it does close, it will take
a lot longer than expected, reducing the investor’s annualized return.

Managers able to analyze these risks correctly have been able to use
merger arbitrage to add significant value on a risk-adjusted basis over
the past decade.
Buchan: A lot of people think convertible bond hedging follows a four-
year cycle in terms of returns. Historically, the strategy has underper-
formed for a quarter or two every three to four years, in 1987, 1990,
1994, 1998, and 2002, and then proceeded to enjoy a strong recovery in
the ensuing year. But what’s behind this pattern? Some of the returns to
convertible bond hedging may come from a liquidity premium the con-
vertible holder collects in return for holding a relatively illiquid security.
If this is the case, then we should see convertible bond hedgers under-
performing when liquidity is prized, as these less liquid assets get
marked down. In fact, regressing the return of convertible hedgers as a
universe on a liquidity measure (such as the spread between Treasury
bills and LIBOR) shows that, when the most liquid instruments are
highly valued, convertible bond hedging does poorly for the quarter
(typically down 2% to 7%). So the question is not whether convertible
bond hedging has an inherent four-year cycle but, rather, what makes
highly liquid instruments more valuable every four years?
But won’t market neutral long-short positions be riskier in
general than the positions taken by an index-constrained
long-only portfolio?
Jacobs: Although a market neutral long-short portfolio may be able to
take larger long (and short) positions in securities with higher (and
lower) expected returns compared with a long-only index-constrained
portfolio, proper integrated optimization will provide for selections and
weightings made with a view to maximizing expected return at the risk
level desired by the investor.
But surely trading costs will be higher?
Levy: The trading costs will largely be a reflection of the leverage in the

portfolio. If a market neutral equity portfolio takes advantage of the full
two-to-one leverage allowed, for example, it will engage in roughly

c02.frm Page 18 Thursday, January 13, 2005 12:12 PM
Questions and Answers About Market Neutral Investing 19
twice as much trading as a comparable long-only portfolio with the
same capital and no leverage. As in any investment strategy, however, it
is important in market neutral to estimate expected returns net of trad-
ing costs. A market neutral portfolio should not trade unless those
trades offer a return above and beyond the cost of trading.
But surely management fees will be higher for market neutral
than for long-only strategies?
Jacobs: If one considers management fees per dollar of securities posi-
tions, rather than per dollar of capital, there is not much difference
between market neutral and long-only. And management fees per active
dollar managed may be lower with market neutral than with long-only.
Index-constrained long-only portfolios contain a substantial “hidden
passive” element; as their active positions consist of only those portions
of the portfolio that represent overweights or underweights relative to
the benchmark, a large portion of the portfolio is essentially passive
index weights. This is not true of market neutral. Because a market neu-
tral portfolio is independent of benchmark weights, its positions can be
fully devoted to performance (i.e., to either enhancing return or reduc-
ing risk).
Levy: Also, most market neutral strategies are managed on a perfor-
mance-fee basis, so the fee will reflect the manager’s value-added.
Should one use a single manager or multiple managers for a
market neutral strategy?
Jacobs: Some investors choose to create a market neutral strategy by
combining a long-only portfolio with a short-only portfolio or with a

derivatives position that neutralizes the long portfolio’s market risk. In
these cases, the manager of the long portfolio may differ from the man-
ager of the short portfolio or from the overlay manager that looks after
the derivatives positions. As we have noted, however, these types of
market neutral strategies cannot benefit from the full flexibility afforded
by long-short portfolio construction. This goes back to our previous
comments on integrated optimization: Only an integrated optimization,
which considers long and short positions simultaneously, results in a
portfolio that is free of benchmark weight constraints, hence able to
exploit fully the risk-reducing and return-enhancing benefits of market
neutral construction using long and short positions. An investor seeking
these benefits from a market neutral strategy should have it managed
under a single roof.

c02.frm Page 19 Thursday, January 13, 2005 12:12 PM
20 MARKET NEUTRAL STRATEGIES
Buchan: But the same may not hold if you are considering multiple mar-
ket neutral strategies. In general, the value-addeds are much less corre-
lated across market neutral managers than across long-only equity
managers. The reason is there are many more styles of market neutral
investing (over 20) than there are of equity investing (growth vs. value,
large cap vs. small cap). As long as the managers have the same expected
return, one can lower the risk of an overall fund more by using many
market neutral managers than by using many long-only equity managers.
Is market neutral too complicated for most investors to
understand?
Buchan: There are two parts to market neutral investing—the strategy
and the securities. As I have noted, the strategy itself is typically no
more complex than what is being done on a long-only basis, with regard
to benchmark-relative investing. There, the issue is how the portfolio

will perform relative to the benchmark; here, the issue is how one secu-
rity (or basket of securities) will perform relative to another. The other
issue is the type of securities used to implement the market neutral strat-
egy. Clearly, there are securities that are simple to evaluate and securi-
ties that are more complex. But this is independent of whether or not
they are being used in a market neutral strategy.
How will it fit into a plan’s overall structure?
Jacobs: First, it is important to understand that market neutral does not
constitute a separate asset class. The asset class to which a market neutral
portfolio belongs depends upon how the portfolio is constructed. A mar-
ket neutral portfolio is essentially a cash investment (albeit with higher
volatility than cash); its value-added is the portfolio’s return relative to
the interest receipts from the short sale proceeds. But one can combine a
market neutral portfolio with various derivatives positions to obtain
exposures to any number of assets—equity, bonds, currency. For example,
a position in stock index futures combined with a market neutral portfo-
lio results in an “equitized” portfolio; its value-added is the portfolio’s
return relative to the equity index return from the futures position.
Levy: Plan sponsors can take advantage of this flexibility to simplify a
plan’s structure. Using market neutral, they can exploit superior security
selection skills (whether in the bond market, the stock market, or the
currency market), while determining the plan’s asset allocation mix sep-
arately, via the choice of derivatives. In this sense, market neutral can be
said to simplify a plan sponsor’s decision-making.

c02.frm Page 20 Thursday, January 13, 2005 12:12 PM
CHAPTER
3
21
Market Neutral Equity Investing

Bruce I. Jacobs, Ph.D.
Principal
Jacobs Levy Equity Management
Kenneth N. Levy, CFA
Principal
Jacobs Levy Equity Management
n market neutral equity investing, the investor buys “winners”—securities
that are expected to do well over the investment horizon—and sells
short “losers”—securities that are expected to perform poorly. Unlike
traditional equity investing, market neutral investing takes full advan-
tage of the investor’s insights: whereas the traditional investor would
act and potentially benefit only from insights about winning securities,
the market neutral investor can act on and potentially benefit from
insights about winners and losers.
To achieve market neutrality, the investor holds approximately
equal dollar amounts of long and short positions. Furthermore, the
securities are selected with careful attention to their systematic risks.
The long positions’ price sensitivities to broad market movements
should virtually offset the short positions’ sensitivities, leaving the over-
all portfolio with negligible systematic risk.
This means that the portfolio’s value does not rise or fall just
because the broad market rises or falls. The portfolio may thus be said
to have a beta of zero. This does not mean that the portfolio is risk-free.
It will retain the risks associated with the selection of the stocks held
long and sold short. The value-added provided by insightful security
selection, however, should more than compensate for the risk incurred.
I

c03.frm Page 21 Thursday, January 13, 2005 12:10 PM
22 MARKET NEUTRAL STRATEGIES

MECHANICS
Exhibit 3.1 illustrates the operations needed to establish a market neu-
tral equity strategy, assuming a $10 million initial investment. Keep in
mind that these operations are undertaken virtually simultaneously,
although they will be discussed in steps.
The Federal Reserve Board requires that short positions be housed
in a margin account at a brokerage firm. The first step in setting up a
long-short portfolio, then, is to find a “prime broker” to administer the
account. This prime broker clears all trades and arranges to borrow the
shares to be sold short.
Exhibit 3.1 shows that, of the initial $10 million investment, $9 mil-
lion is used to purchase the desired long positions. These are held at the
prime broker, where they serve as the collateral necessary, under Federal
Reserve Board margin requirements, to establish the desired short posi-
tions. The prime broker arranges to borrow the securities to be sold
short. Their sale results in cash proceeds, which are delivered to the
stock lenders as collateral for the borrowed shares.

1
Federal Reserve Board Regulation T (“Reg T”) requires that a mar-
gined equity account be at least 50% collateralized to initiate short
sales.

2
This means that the investor could buy $10 million of securities
and sell short another $10 million, resulting in $20 million in equity
positions, long and short. As Exhibit 3.1 shows, however, the investor
has bought only $9 million of securities, and sold short an equal
amount. The account retains $1 million of the initial investment in cash.
EXHIBIT 3.1 Market Neutral Deployment of Capital (Millions of Dollars)

Source: Bruce I. Jacobs and Kenneth N. Levy, “The Long and Short on Long-Short,”
Journal of Investing (Spring 1997).

c03.frm Page 22 Thursday, January 13, 2005 12:10 PM
Market Neutral Equity Investing 23
This “liquidity buffer” serves as a pool to meet cash demands on the
account. For instance, the account’s short positions are marked to market
daily. If the prices of the shorted stocks increase, the account must post
additional capital with the stock lenders to maintain full collateralization;
conversely, if the shorted positions fall in price, the (now overcollateral-
ized) lenders release funds to the long-short account. The liquidity buffer
may also be used to reimburse the stock lenders for dividends owed on
the shares sold short, although dividends received on stocks held long
may be able to meet this cash need. In general, a liquidity buffer equal to
10% of the initial investment is sufficient.
The liquidity buffer will earn interest for the market neutral
account. We assume the interest earned approximates the Treasury bill
rate. The $9 million in cash proceeds from the short sales, posted as col-
lateral with the stock lenders, also earns interest. The interest earned is
typically allocated among the lenders, the prime broker, and the market
neutral account; the lenders retain a small portion as a lending fee, the
prime broker retains a portion to cover expenses and provide some
profit, and the long-short account receives the rest. The exact distribu-
tion is a matter for negotiation, but we assume the amount rebated to
the investor (the “short rebate”) approximates the Treasury bill rate.

3
The overall return to the market neutral equity portfolio thus has two
components: an interest component and an equity component. The perfor-
mances of the stocks held long and sold short will determine the equity com-

ponent. As we will see below, this component will be independent of the
performance of the equity market from which the stocks have been selected.
Market Neutrality
The top half of Exhibit 3.2 illustrates the performance of a market neu-
tral equity portfolio. It assumes the market rises by 30%, while the long
positions rise by 33% and the short positions by 27%. The 33% return
increases the value of the $9 million in long positions to $11.97 million,
for a $2.97 million gain. The 27% return on the shares sold short
increases their value from $9 million to $11.43 million; as the shares are
sold short, this translates into a $2.43 million loss for the portfolio.
The net gain from equity positions equals $540,000, or $2.97 million
minus $2.43 million. This represents a 6.0% return on the initial equity
investment of $9 million, equal to the spread between the returns on the
long and short positions (33% minus 27%). As the initial equity investment
represented only 90% of the invested capital, however, the equity compo-
nent’s performance translates into a 5.4% return on the initial investment
(90% of 6.0%). (Of course, if the shorts had outperformed the longs, the
return from the equity portion of the portfolio would be negative.)

c03.frm Page 23 Thursday, January 13, 2005 12:10 PM
24
EXHIBIT 3.2
Hypothetical Performance in Bull and Bear Markets (millions of dollars)
Source:
Bruce I. Jacobs and Kenneth N. Levy, “The Long and Short on Long-Short,”
Journal of Investing
(Spring 1997).

c03.frm Page 24 Thursday, January 13, 2005 12:10 PM
Market Neutral Equity Investing 25

We assume the short rebate (the interest received on the cash proceeds
from the short sales) equals 5%. This amounts to $450,000 (5.0% of $9
million). The interest earned on the liquidity buffer adds another $50,000
(5.0% of $1 million). (A lower rate would result, of course, in a lower
return.) Thus, at the end of the period, the $10 million initial investment
has grown to $11.04 million. The long-short portfolio return of 10.4%
comprises a 5% return from interest earnings and a 5.4% return from the
equity positions, long and short.
The bottom half of Exhibit 3.2 illustrates the portfolio’s perfor-
mance assuming the market declines by 15%. The long and short posi-
tions exhibit the same market-relative performances as above, with the
longs falling by 12% and the shorts falling by 18%. In this case, the
decline in the prices of the securities held long results in an ending value
of $7.92 million, for a loss of $1.08 million. The shares sold short, how-
ever, decline in value to $7.38 million, so the portfolio gains $1.62 mil-
lion from the short positions. The equity positions thus post a gain of
$540,000—exactly the same as the net equity result experienced in the
up-market case. The interest earnings from the short rebate and the
liquidity buffer are the same as when the market rose, so the overall
portfolio again grows from $10 million to $11.04 million, for a return
of 10.4%. (Obviously, if the shorts had fallen less than the longs, or
interest rates had declined, the return would be lower.)
A market neutral equity portfolio is designed to return the same
amount whether the equity market rises or falls. A properly constructed
market neutral portfolio, if it performs as expected, will incur virtually
no systematic, or market, risk; its return will equal its interest earnings
plus the net return on (or the spread between) the long and short posi-
tions. The equity return spread is purely active, reflecting the investor’s
stock selection skills; this return spread is not diluted (or augmented) by
the underlying market’s return.

ADVANTAGES OF MARKET NEUTRALITY AND SHORT SELLING
Exhibit 3.2 highlights one obvious benefit of a market neutral equity
approach—elimination of market risk. In a market neutral portfolio, the
returns to active investing are no longer hostage to the sometimes over-
whelming effects of broad market moves. Of course, this freedom comes
at a price: The market neutral portfolio also does not benefit from the
positive return that equity, as an asset class, has historically enjoyed
(although, as we will see in Chapter 8, the investor can recapture this
equity risk premium by using derivatives).

c03.frm Page 25 Thursday, January 13, 2005 12:10 PM
26 MARKET NEUTRAL STRATEGIES
Another obvious advantage of a market neutral approach to equity
investing is that it allows the investor to exploit insights about poor per-
formers as well as good performers. Long positions in stocks that are
undervalued and short positions in stocks that are overvalued make use
of all available market information to enhance returns. Not being able
to use insights about overvalued as well as undervalued stocks is like
tearing the Wall Street Journal in half and reading only the good news.
Some of the return advantages of a market neutral equity strategy
can be illustrated by comparing the return payoffs of a very basic long-
plus-short portfolio with those of a long-only portfolio.

4
Exhibit 3.3 shows the payoffs to a long-only portfolio. The line for
the market portfolio can be viewed as the return to a long passive posi-
tion in the market. The benefit of active management is presumably an
excess return, or alpha. This excess return shifts the active long portfo-
lio’s payoff upward relative to the long market portfolio.
Exhibit 3.4 shows the payoffs to the short portfolio. The short market

portfolio can be viewed as the return to a short passive position in the
EXHIBIT 3.3 Payoffs to a Long Portfolio
Source: Bruce I. Jacobs and Kenneth N. Levy, “Long/Short Equity Investing,”
Journal of Portfolio Management (Fall 1993).

c03.frm Page 26 Thursday, January 13, 2005 12:10 PM
Market Neutral Equity Investing 27
market. When an investor sells short, however, proceeds are generated,
and those proceeds earn interest. The short market portfolio line can thus
be shifted upward by the amount of interest, as shown in the figure. Active
management should produce an excess return, or alpha, on top of the mar-
ket-return-plus-interest line. The payoff line for the active short portfolio
thus recognizes the short passive market return, the interest received on
the short-sale proceeds, and the excess return due to active management.
A long-plus-short portfolio combines the long portfolio and the
short portfolio discussed above. Exhibit 3.5 shows that the payoff for
this long-plus-short portfolio equals the alpha from the short portfolio
plus the alpha from the long portfolio plus the interest earned on the
proceeds from the short sales.
A Question of Efficiency
Exhibits 3.2 and 3.5 assume symmetric market-relative returns for the
long and short positions; that is, the long positions and the short posi-
EXHIBIT 3.4 Payoffs to a Short Portfolio
Source: Bruce I. Jacobs and Kenneth N. Levy, “Long/Short Equity Investing,”
Journal of Portfolio Management (Fall 1993).

c03.frm Page 27 Thursday, January 13, 2005 12:10 PM
28 MARKET NEUTRAL STRATEGIES
tions are assumed to have the same absolute market-relative return.
However, there are reasons to believe that short-sale candidates—the

most overpriced stocks, which offer the lowest expected returns—may
be more common or more mispriced than the underpriced stocks that
constitute the candidates for purchase. In that case, one might expect
higher excess returns from short positions than from long positions.
Exhibit 3.6 describes a world divided according to whether short sell-
ing is restricted or unrestricted and whether investor opinion is uniform or
diverse. When investor opinion is diverse and short selling is restricted, the
market portfolio is no longer efficient.

5
If investors have diverse opinions,
some will be more optimistic and others more pessimistic; if the pessimistic
investors face more obstacles in selling short than the optimistic investors
face in purchasing long, optimism in pricing will tend to prevail.

6
Investor optimism is supported by several institutional features of the
stock market. Corporations, for example, are generally eager to publicize
good news, but they may delay releasing bad news or attempt to disguise
it via window-dressing or, at times, actual fraud. Stock prices may thus
reflect good news more quickly and unambiguously than bad news.
EXHIBIT 3.5
Payoffs to a Long-Plus-Short Portfolio
Source: Bruce I. Jacobs and Kenneth N. Levy, “Long/Short Equity Investing,”
Journal of Portfolio Management (Fall 1993).

c03.frm Page 28 Thursday, January 13, 2005 12:10 PM
Market Neutral Equity Investing 29
EXHIBIT 3.6 Impact of Divergence of Opinion and Restricted Shorting on Market
Equilibrium

Source: Bruce I. Jacobs and Kenneth N. Levy, “Long/Short Equity Investing,”
Journal of Portfolio Management (Fall 1993).
Practices at brokerage firms, too, favor optimism in security pricing.
Attention has lately focused, for example, on whether analysts’ recom-
mendations are swayed by their firms’ investment banking interests; in
cases where analyst compensation depends in some measure on the
profitability of investment banking, analysts may feel pressured to put a
positive spin on analyses of companies that are existing or potential
investment banking clients. Positive recommendations may also be
expected to result in more profits from brokerage than negative recom-
mendations; all customers are potential purchasers, whereas commis-
sions from sales will come primarily from customers who already own
the stock.
These features of the securities business may combine with aspects
of investor psychology to create stock bubbles and fads, in which rising
prices become detached from any rational estimate of “fair” value.
Recent history gives us the example of the tech stock bubble of 1999–
2000, in which momentum investors bid up to extraordinary levels the
prices of some companies with highly volatile and even negative earn-
ings.

7
As that example showed, investor optimism can result in substan-

c03.frm Page 29 Thursday, January 13, 2005 12:10 PM
30 MARKET NEUTRAL STRATEGIES
tial departures of prices from underlying fundamental values, and these
departures can last for nontrivial periods.
Theoretically, as shares become overpriced, given underlying funda-
mentals, “rational” investors, including value investors, might be expected

to sell these overpriced shares short, reducing the upward pressure on
prices. Their ability, or willingness, to do so may be limited, however, for
several reasons.
The ability to sell short is generally more restricted than the ability
to buy long. Short selling may be legally or contractually forbidden or
constrained. Even investors not so constrained may nevertheless face
obstacles to short selling. For instance, sometimes shares may not be
readily available for borrowing. And at some times, the investor will not
be able to sell short because of exchange uptick rules, which forbid
short sales when share price is falling.
Willingness is another factor. Even if rational investors are sure that
securities are overpriced (or underpriced, for that matter), they are not
likely to be willing to take unlimited offsetting positions, because they
cannot be sure that prices won’t continue to move against them. Inves-
tors who sold short tech stocks in early 1999, for example, ended up
taking on considerable risk, as the tech bubble kept inflating for
months. These investors suffered mounting losses on short positions
until the bubble burst in the spring of 2000. Furthermore, many may
not have been able or willing to hang on to enjoy a reversal in fortune,
as they faced increasing demands for collateral to cover the rise in the
prices of their short positions. Thus considerations of risk and liquidity
may limit investors’ willingness (and ability) to sell short in sufficient
magnitude to offset overpricing at all times.
Short sales have historically accounted for a small, though rising,
percentage of shares outstanding. Short interest on the New York Stock
Exchange, about 0.2% two decades ago, is now about 1.6%. Of course,
only a portion of this interest is motivated by security selection; most
short sales are undertaken by dealers supplying liquidity or investors
shorting for risk-hedging, tax-deferral, or arbitrage purposes.
In a market characterized by diverse opinion and restricted short

selling, then, inefficiencies might be concentrated in overpriced stocks.
In that case, short sales of the most overpriced stocks may be able to
offer higher excess returns than long purchases of underpriced stocks.
When market inefficiency is greater on the short side of the market than
the long side, the excess return to the short portfolio in Exhibit 3.4 may
be expected to be greater than the excess return to the long portfolio in
Exhibit 3.3, and the returns to the long and short positions illustrated in
Exhibit 3.2 will not be symmetric about the market return, but will be
greater for short positions.

c03.frm Page 30 Thursday, January 13, 2005 12:10 PM
Market Neutral Equity Investing 31
INTEGRATED OPTIMIZATION
The ability to sell short constitutes a material advantage for a market
neutral investor compared with a long-only investor. Consider, for
example, a long-only investor who has an extremely negative view
about a typical stock. The investor’s ability to benefit from this insight is
very limited. The most the investor can do is exclude the stock from the
portfolio, in which case the portfolio will have about a 0.01% under-
weight in the stock, relative to the underlying market (as the median-
capitalization stock in the Russell 3000 universe has a weighting of
0.01%). Those who do not consider this to be a material constraint
should consider what its effect would be on the investor’s ability to
overweight a typical stock. It would mean the investor could hold no
more than a 0.02% long position in the stock—a 0.01% overweight—
no matter how attractive its expected return.
The ability to short, by increasing the investor’s leeway to act on his
or her insights, has the potential to enhance returns from active security
selection. This potential may be especially appealing if, as the discussion
above has suggested, short-sale candidates are less efficiently priced

than purchase candidates. Even if this is not the case, however—if over-
priced securities are no more inefficient than underpriced securities—
market neutral construction can improve upon the results of long-only
portfolio management.
The scope of the improvement offered by market neutral investing
depends critically on the way in which the portfolio is constructed. In
particular, an integrated optimization that considers both long and
short positions simultaneously frees the investor not only from the non-
negativity constraint imposed on long-only portfolios, but also frees the
market neutral portfolio from the restrictions imposed by securities’
benchmark weights. To see this, it is useful to examine in some detail
the ways in which market neutral portfolios can be constructed, and
their implications for portfolio performance.
For instance, many investors construct market neutral portfolios by
combining a long-only portfolio, perhaps a preexisting one, with a
short-only portfolio. This results in a long-plus-short portfolio similar
to the one illustrated in Exhibit 3.5. The long side of this portfolio is
identical to a long-only portfolio, hence it offers no benefits in terms of
incremental return or reduced risk. Furthermore (assuming no greater
inefficiencies on the short side), the short side of this portfolio is statisti-
cally equivalent to the long side, hence to the long-only portfolio. In
effect:

α
L
=

α
S
=


α
LO

c03.frm Page 31 Thursday, January 13, 2005 12:10 PM
32 MARKET NEUTRAL STRATEGIES

ω
L
=

ω
S
=

ω
LO
The excess return or alpha,

α
L
, of the long side of the long-plus-short
portfolio will equal the alpha of the short side,

α
S
, which will equal the
alpha of the long-only portfolio,

α

LO
. Furthermore, the residual risk of
the long side of the long-plus-short portfolio,

ω
L
, will equal the residual
risk of the short side,

ω
S
, which will equal the residual risk of the long-
only portfolio,

ω
LO
.
These equivalencies reflect the fact that all the portfolios, the long-
only portfolio and the long and short components of the long-plus-short
portfolio, are constructed relative to a benchmark index. Each portfolio
is active in pursuing excess return relative to the underlying benchmark
only insofar as it holds securities in weights that depart from their bench-
mark weights. However, departures from benchmark weights introduce
residual risk. Controlling portfolio risk thus involves balancing expected
excess (to benchmark) returns against the added risk they introduce. In
this balancing act, the investor faces the probability of having to forgo
some increment of expected return in order to reduce portfolio residual
risk. Portfolio construction is benchmark-constrained.

8

Consider, for example, an investor who does not have the ability to dis-
criminate between good and bad oil stocks, or who believes that no oil
stock will significantly out- or underperform the underlying benchmark in
the near future. In long-plus-short, this investor may have to hold some oil
stocks in the long portfolio and short some oil stocks in the short portfolio,
if only to control each portfolio’s residual risk relative to the benchmark.
In long-plus-short, the advantage offered by the flexibility to short
is also curtailed by the need to control risk by holding or shorting secu-
rities in benchmark-like weights. The ratio of the performance of the
long-plus-short portfolio to that of the long-only portfolio can be
expressed as follows:
where IR is the information ratio, or the ratio of excess return to resid-
ual risk,

α/

ω, and

ρ
L+S
is the correlation between the alphas of the long
and short sides of the long-plus-short portfolio. If this correlation is less
than one, the long-plus-short portfolio will enjoy greater diversification
and reduced risk relative to a long-only portfolio, for an improvement
in IR. However, a long-only portfolio can derive a similar benefit by
adding a less than fully correlated asset with comparable risk and
return, so this is not a benefit unique to long-short.

9
IR

LS+
IR
LO

2
1 ρ
LS+
+
=

c03.frm Page 32 Thursday, January 13, 2005 12:10 PM
Market Neutral Equity Investing 33
The Real Benefits of Market Neutral
The real benefits of market neutral emerge only when the portfolio is
conceived of and constructed as a single integrated portfolio of long and
short positions.

10
In this framework, market neutral is not a two-portfo-
lio strategy. It is a one-portfolio strategy in which the long and short
positions are determined jointly within an optimization that takes into
account the expected returns of the individual securities, the standard
deviations of those returns, and the correlations between them, as well
as the investor’s tolerance for risk.
With integrated optimization, a market neutral portfolio is not con-
strained by benchmark weights. Once an underlying benchmark has been
used to determine the systematic risks of the candidate securities, its role
in market neutral construction is effectively over. The offsetting market
sensitivities of the aggregate long and aggregate short positions eliminate
market sensitivity and the need to consider benchmark weights in estab-

lishing security positions. The investor is not constrained to moving away
from or toward benchmark weights in order to pursue return or control
risk. Rather, capital can be allocated without regard to the securities’
weights in the underlying benchmark, as offsetting long and short posi-
tions are used to control portfolio risk. To establish a 1% overweight or a
1% underweight, the investor merely has to allocate 1% of capital long
or allocate 1% of capital short.
Suppose, for example, that an investor’s strongest insights are about
oil stocks, some of which are expected to do especially well and some
especially poorly. The investor does not have to restrict the portfolio’s
holdings of oil stocks to benchmark-like weights in order to control the
portfolio’s exposure to oil sector risk. The investor can allocate much of
the portfolio to oil stocks, held long and sold short. The offsetting long
and short positions control the portfolio’s exposure to the oil factor.
Conversely, suppose the investor has no insights into oil stock
behavior. Unlike the long-only and long-plus-short investors discussed
above, the integrated market neutral investor can totally exclude oil
stocks from the portfolio. The exclusion of oil stocks does not increase
portfolio risk, because the integrated market neutral portfolio’s risk is
independent of any security’s benchmark weight. At the same time,
freed of the need to hold deadweight in the form of securities that offer
no abnormal expected returns, the investor can allocate more capital to
securities that do offer expected abnormal returns.
In an integrated optimization, selection of the securities to be held
long is determined simultaneously with the selection of the securities to
be sold short. The result is a single market neutral portfolio, not one
long portfolio and one short portfolio. Just as one cannot attribute the
qualities of water, its wetness say, to its hydrogen or oxygen compo-

c03.frm Page 33 Thursday, January 13, 2005 12:10 PM

34 MARKET NEUTRAL STRATEGIES
nents separately, one cannot reasonably dissect the performance of an
integrated market neutral portfolio into one element attributable to
long positions alone and another attributable to short positions alone.
Only jointly do the long and short positions define the portfolio. Long
and short excess returns, or alphas, are thus meaningless concepts.
Rather than being measurable as long and short performance in
excess of an underlying benchmark, the performance of the equity por-
tion of the integrated market neutral portfolio is measurable as the
overall return on the long and short positions—or the spread between
the long and short returns—relative to their risk. Compared with the
excess return/residual risk of long-only management, this performance
should be enhanced by the elimination of benchmark constraints, which
allows the market neutral portfolio increased flexibility to implement
investment insights, both long and short.
OPERATIONAL CONSIDERATIONS
Market neutral construction maximizes the benefit obtained from poten-
tially valuable investment insights by eliminating long-only investing’s
constraint on short selling and the need to converge to securities’ bench-
mark weights in order to control portfolio risk. While market neutral
offers advantages over long-only, however, it also involves complications
not encountered in long-only management. Many of these complications
are related to the unique trading requirements of market neutral and to
its use of short selling.
Trading Market Neutral Portfolios
The trading of market neutral equity portfolios is more complicated
than that of long-only portfolios. First, the values and market sensitivi-
ties of the aggregate long and aggregate short positions must be kept in
balance on a real-time basis in order to provide market neutrality. Sec-
ond, the account must meet Federal Reserve, stock exchange, and indi-

vidual broker initial and maintenance margin requirements. Third,
marks to market on short positions must be satisfied.
Ensuring that overall portfolio neutrality is maintained throughout a
trading program may require that long or short trades be sped up or slowed
down relative to their occurrence in a typical long-only portfolio. Because
short sales are more problematic and more likely to experience delays (as
the result of uptick trading restrictions), imbalances may occur. In that
event, securities may have to be sold long or shorts covered until balance is
restored. Derivatives may also be used to correct temporary imbalances.

c03.frm Page 34 Thursday, January 13, 2005 12:10 PM
Market Neutral Equity Investing 35
Various margin requirements govern a market neutral portfolio at
its establishment and throughout its life. As noted earlier, under Federal
Reserve Board Regulation T, establishment of an equity short position
requires at least 50% margin. Once established, short positions are sub-
ject to less stringent maintenance margins, set by the exchanges or indi-
vidual brokers. NYSE Rule 431 sets maintenance margins at 25% of the
stock price for long positions, at the greater of $5 or 30% of stock price
for short positions when the stock is more than $5 a share, and at the
greater of $2.50 or the stock price for short positions when the stock is
less than $5 a share. Individual brokers generally require more than
30% collateralization.
An account that falls below maintenance margin requirements will
have to decrease its securities exposure by covering shorts or selling
longs or to increase its capital by adding cash. An account that meets
maintenance margin requirements but not the initial margin require-
ment is restricted in the sense that it can make no transactions that
would cause further reduction in margin, such as shorting or purchasing
additional shares on margin or withdrawing cash.

Short positions are marked to market daily. Increases in a stock’s
price will require that the short seller deposit additional collateral with
the stock lenders. Declines will release collateral from the stock lenders
to the short seller’s margin account. The liquidity buffer serves as a cash
pool for meeting and receiving these obligations. It may also be used to
reimburse stock lenders for any dividends paid on the short positions. In
most cases, these payments can be met from the dividends on the long
positions. When the dividend yield on the longs is less than that on the
shorts, however, the liquidity buffer may be pressed into service.
Determination of the size of the liquidity buffer is a balancing act.
Investors will want to be able to invest as much capital as possible,
hence have the smallest liquidity buffer practical. At the same time, they
will want to avoid having to borrow from the broker in order to meet
required payments. Borrowing at the broker call rate can be costly and
may have tax repercussions for a tax-exempt investor. A liquidity buffer
equal to 10% of capital generally provides a reasonable tradeoff between
these competing goals.
Exhibits 3.7 and 3.8 illustrate how maintenance of long-short balance,
margin requirements, and marks to market can require portfolio trading.
Exhibit 3.7 shows the effects on a $10 million market neutral portfolio
when both long and short positions either fall in value by 50% or rise in
value by 100%. At the outset, the market neutral portfolio easily meets
initial margin requirements, as long and short positions totaling $18
million ($9 million long plus $9 million short) are collateralized by $10

c03.frm Page 35 Thursday, January 13, 2005 12:10 PM
36
EXHIBIT 3
.
7

Trading Required When Long and Short Positions Fall 50% or Rise 100% (millions of dollars)
Source:
Bruce I. Jacobs and Kenneth N. Levy, “The Long and Short on Long-Short,”
Journal of Investing
(Spring 1997).
EXHIBIT 3.8
2% Long-Short Spread (millions of dollars)
Source:
Bruce I. Jacobs and Kenneth N. Levy, “The Long and Short on Long-Short,”
Journal of Investing
(Spring 1997).
Initial
Values Return Gain/Loss Owe/Owed
New
Values
Action After-Action
Values
Fall or Rise Fall Rise Fall Rise Fall Rise
Fall Rise Fall Rise Fall or Rise
Long $9 –50% +100% –$4.5 +$9
$4.5 $18 Buy
$4.5
Sell
$9
$9
Short $9 –50% +100% +$4.5 –$9 Owed
$4.5 by
Lenders
Owe
Lenders

$9
$4.5 $18 Sell
Short
$4.5
Cover
$9
$9
Cash $1
$5.5 –$8
$1
Equity $10
$10 $10
$10
Margin 55.6%
111.1% 27.8%
55.6%
Initial Values Return Gain/Loss Owe/Owed
New Values Action After-Action Values
Long $9 +4% +$0.36
$9.36 Sell $0.198
$9.162
Short $9 +2% –$0.18 Owe Lenders $0.18
$9.18 Cover $0.018 $9.162
Cash
$1
$0.82
$1.018
Equity $10
$10.18
$10.18

Margin 55.6%
54.9%
55.6%

c03.frm Page 36 Thursday, January 13, 2005 12:10 PM
Market Neutral Equity Investing 37
million in equity (the longs plus the cash in the liquidity buffer), for a
margin of 55.6%.
A 50% decline in the values of the longs and shorts results in the
securities’ lenders being overcollateralized; they will have to transfer
$4.5 million to the market neutral account. The liquidity buffer will
then be larger than needed. The investor can buy an additional $4.5 mil-
lion in securities and sell short an additional $4.5 million, restoring the
account to its initial values.
A 100% increase in the values of the longs and shorts results, by
contrast, in the securities’ lenders being undercollateralized; they hold
only $9 million in cash proceeds from the initial short sales, but the secu-
rities they lent are now worth $18. The long-short account must transfer
an additional $9 million to the stock lenders. Taking this sum from the
liquidity buffer, however, would result in a deficit of $8 million and leave
the overall portfolio undermargined, by brokers’ standards, at 27.8%. In
order to meet the marks to market on the short positions and reestablish
maintenance margin, the investor can sell $9 million worth of securities
held long and cover $9 million worth of securities sold short. This will
restore the portfolio to its initial starting values.
The behavior of the long and short values in Exhibit 3.7 is consistent
with the effects of underlying market movements; that is, the equivalent
systematic risks of the long and short positions would lead to equivalent
value changes in the absence of residual, or nonsystematic, risk. We can
thus infer that, even though the return on a basic market neutral equity

portfolio is neutral to overall equity market movements, market move-
ments can have implications for the implementation of market neutral
strategies; in particular, they may necessitate trading activity.
In practice, of course, one is unlikely to experience market move-
ments of the magnitudes illustrated. More likely movements would lead
to fewer violations of margin requirements and less trading. With a 5%
market rise, for example, the initial long and short positions in Exhibit
3.7 could be expected to increase to $9.45 million, calling for a payment
of $0.45 million to the securities’ lenders and a reduction in the liquidity
buffer to $0.55 million. There would be no violation of margin (margin
would be 52.9%), but restoring the liquidity buffer would require selling
$0.45 million worth of long positions and covering $0.45 million worth
of shorts. Market declines would be even less problematic. A market
decline of 20%, in line with what occurred on Black Monday 1987,
would lead to a decline in the value of the long and short positions from
$9 to $7.2 million and the liquidity buffer’s receipt of $1.8 million from
the securities’ lenders.
Exhibit 3.7 assumes that returns to the long and short positions are
equal. If the market neutral portfolio performs as expected, however, it

c03.frm Page 37 Thursday, January 13, 2005 12:10 PM