Active equity strategies - Long-short portable alpha and mar...

Learning Outcomes

After reading this article, you will be able to describe the concepts, structures, and key CFA assessment areas of active equity long-short, portable alpha, and market-neutral strategies. You will learn to compare their risk and return features, analyze their impact on portfolio construction, and identify critical implementation considerations for the CFA Level 3 exam.

CFA Level 3 Syllabus

For CFA Level 3, you are required to understand active equity strategies that extend beyond traditional long-only investing. In particular, ensure your revision covers:

• The objective and mechanics of long-short equity strategies and their role in managing equity exposure and diversifying risk
• The definition and relevance of portable alpha techniques, including separation of alpha and beta exposures
• The characteristics, structure, and practical implementation of market-neutral equity strategies
• How to assess the practical, risk, and performance implications of each strategy type in a multi-asset portfolio context
• The use of derivatives and borrowing in constructing portable alpha and market-neutral exposures

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the main purpose of a market-neutral active equity strategy?
2. In constructing a portable alpha strategy, what two exposures are typically separated?
3. True or false? A long-short equity strategy always reduces a portfolio’s beta to zero.
4. Briefly explain the potential benefit of combining a market-neutral alpha strategy with a broad market index.

Introduction

Long-only equity portfolios have historically been the norm for asset managers and institutional investors. However, advances in derivatives, exposure management, and risk budgeting have made active equity strategies that combine long and short positions increasingly important. These techniques allow investors to seek absolute return, isolate alpha from beta, and construct portfolios with reduced market risk or targeted exposures. This article explains the core principles and assessment-relevant features of long-short, portable alpha, and market-neutral equity strategies as tested in the CFA Level 3 exam.

Key Term: long-short equity strategy
An approach to equity investing that involves buying (going long) undervalued stocks and selling (going short) overvalued stocks to profit from both security selection and market direction.

Key Term: portable alpha
A structure separating an investor’s alpha exposure (from skill) from beta exposure (market risk), allowing for the transfer (“porting”) of alpha to different beta exposures.

Key Term: market-neutral strategy
An equity investment approach that seeks to neutralize net exposure to overall market risk (systematic beta), typically by carefully balancing long and short positions.

ACTIVE EQUITY STRATEGIES: OVERVIEW

Active equity strategies move beyond taking long positions in a selected list of stocks. By constructing portfolios with both long and short exposures, the manager can seek to profit from relative value, reduce net market risk, or achieve targeted portfolio outcomes regardless of market direction. CFA Level 3 focuses on three key active strategies:

1. Long-short equity strategies
2. Portable alpha
3. Market-neutral portfolios

Each has distinct objectives, construction techniques, and risk implications but shares a reliance on skillful active management and, often, derivatives.

LONG-SHORT EQUITY STRATEGIES

A long-short equity manager takes long positions in stocks viewed as undervalued and short positions in stocks seen as overvalued. This increases the opportunity set for security selection and allows the manager to express negative views as well as positive ones. The net portfolio beta may be positive (net long), neutral, or negative (net short), depending on risk appetite and implementation.

Key Term: net exposure
The portfolio's aggregate market exposure, calculated as the percentage of long positions minus that of short positions.

Worked Example 1.1

Suppose a portfolio is 120% long and 80% short, using borrowed funds. What is the net and gross exposure?

Answer:
Net exposure = 120% - 80% = 40% (net long) Gross exposure = 120% + 80% = 200%

Strategy Features

• Flexibility: Able to benefit from both rising and falling stocks.
• Risk: Allows higher gross exposure, which can magnify alpha and idiosyncratic risk.
• Implementation: Requires access to stock borrowing and may use derivatives for efficiency.

Revision Tip

Remember: The use of borrowing in long-short strategies can magnify both return and risk, making portfolio risk management and borrowing constraints a key exam focus.

PORTABLE ALPHA

Portable alpha decouples a manager’s value-added (alpha) from general market risk (beta). The active manager constructs a market-neutral (“pure alpha”) portfolio expected to generate excess returns over cash, then synthetically adds (ports) the desired market beta exposure using derivatives or index products.

Structure

1. Invest primarily in a market-neutral alpha source (e.g., long-short or hedge fund).
2. Overlay with derivatives (e.g., equity index futures or swaps) to capture the target market’s beta.
3. The combined portfolio seeks to deliver the market return plus the alpha from the manager’s skill, regardless of the base alpha strategy’s asset class.

Key Term: alpha
The return generated by a manager’s skill in excess of relevant market risk factors.

Key Term: beta
The exposure to systematic risk or market movements of a portfolio.

Worked Example 1.2

An endowment invests $10m in a market-neutral alpha fund expected to return cash +2%. It also invests synthetically in $10m S&P 500 futures. If the S&P 500 returns 8% and cash returns 2%, what is the expected return before fees?

Answer:
Portfolio return = S&P 500 return (beta) + alpha fund return = 8% + 2% = 10%

Benefits

• Separation of skill: Isolates true manager alpha.
• Flexible beta: Alpha can be ‘ported’ to any desired beta (e.g., S&P 500, bond index, commodities).
• Potential for diversification: Allows addition of alpha sources uncorrelated with portfolio beta.

MARKET-NEUTRAL EQUITY STRATEGIES

A market-neutral portfolio is constructed so that exposure to general market movements (systematic risk) is minimal or close to zero. This is usually achieved by closely matching the portfolio’s long and short exposures by dollar value, beta, or factor exposure.

• Objective: Deliver alpha (skill-based return) independent of overall market trends.
• Method: Construct long positions in expected outperformers; short positions in expected underperformers; ensure exposures offset to eliminate beta.
• Implementation: May require borrowing to increase gross exposure and potential return, as the net market exposure is close to zero.
• Common variants: Quantitative statistical arbitrage, fundamental pairs trading, and multi-factor market-neutral portfolios.

Worked Example 1.3

A manager creates a dollar-neutral portfolio: $10m long, $10m short. If the market falls 15%, but long positions fall 10% and shorted stocks fall 20%, what is the net return?

Answer:
Long side loss: -10% of $10m = -$1m; Short side gain: +20% of $10m = +$2m; Net gain = $1m or +5% on $20m gross, +10% on initial $10m outlay.

Performance Characteristics

• Reduced beta risk: Portfolio hedged against general market moves.
• Idiosyncratic risk remains: Relies solely on manager skill.
• Borrowing impact: Higher borrowing needed to achieve significant returns from small relative mispricings, increasing risk if skill is weak.

Exam Warning

Watch for exam traps confusing gross and net exposures, or assuming zero beta always means zero volatility.

PRACTICAL ASSESSMENT: COMPARISON AND PORTFOLIO IMPACT

Summary

Active equity strategies using long-short, portable alpha, and market-neutral constructions offer advanced tools for achieving targeted risk and return in CFA-level portfolios. These approaches can isolate manager skill, reduce market risk, and diversify sources of return but require careful understanding of exposure, borrowing, and implementation. Exam questions frequently test your ability to compare, structure, and assess the risk and implementation requirements of these strategies.

Key Point Checklist

This article has covered the following key knowledge points:

• Distinction between long-short equity, portable alpha, and market-neutral equity strategies
• The concept of separating alpha and beta exposures for portable alpha
• How market-neutral strategies eliminate systematic market risk
• Structure and risk implications of long-short positions and net/gross exposures
• Portfolio construction, borrowing, and risk management for advanced equity strategies
• CFA assessment focus: structure, risk/return, and practical impacts in multi-asset portfolios

Key Terms and Concepts

• long-short equity strategy
• portable alpha
• market-neutral strategy
• net exposure
• alpha
• beta