Under asset allocation, Long and short positions on the same risk factors isolate the respective risks.
Under equity portfolio,
market neutral long-short investing /short extension eliminate systematic risks, zero beta /only get exposed to the unsystematic risks.
Are the above contradictory?
Not really.
To isolate inflation you would short nominal bonds and long TIPS. The risk free rate cancels out and all you’re left with is inflation.
A market neutral long/short cancels out the beta exposure and all you’re left with is alpha.
I don’t get your first paragraph. Are u hedging inflation or left with inflation risk?
No, we’re isolating exposure to the inflation risk factor.
Think about TIPS as two components. 1) risk free rate. 2) inflation. If we only want exposure to the inflation risk factor (and no exposure to the risk free rate), we need to isolate this risk factor by buying TIPS and shorting nominal risk free bonds (rf + inflation - rf = inflation).
This is the same concept as an equity market neutral strategy gaining alpha exposure and eliminating beta exposure (beta + alpha - beta = alpha).
The TIPS example shows that we are exposed to the inflation risk, the unsystematic risk that we are trying to isolate…
Yes, that’s the point. We have used long and short positions to isolate one specific risk factor.
Thank u, Kiwi. I think it was misunderstood from me semantically. “Isolation” is not removing the factor itself, but removing all other affecting factors and only get exposed to this specific “ isolated” risk factor.
Really thanks for your patience!!!