First, what is a good definition of short alpha. Then, can anyone explain how exactly do you generate short alpha using the short-extension strategy (e.g., 120/20). Thanks,
Long alpha is from adding value by purchasing undervalued securities / securities that will increase in value. Short alpha is from adding value by selling overvalued securities / securities that will increase in value. For a long-only portfolio, the most you can ‘underweight’ a stock (negative active position) that you don’t like is by its % weight in the benchmark. So you could chose to not hold a stock that makes up 3% of the CORRECT benchmark, and you are in effect taking a -3% position in that security. In a short extension strategy, you can take positive and negative active positions in stocks and earn long and short alpha. Your short alpha is still somewhat limited because you can’t short 100% of the portfolio value. In a 120/20 strategy, you can take negative active positions w/ 20% of the portfolio value. In a Long-short strategy, there’s no limitation on how the long or short side as you can take up to 100% long and up to 100% short positions. A market neutral strategy is similar, except that you will always take 100% long / 100% short so that you have zero beta exposure.
Overvalue share - short it. When price goes down, you can buy it back at lower price. So your sale price - buy price is the alpha. Short extension is in between short only and long-short. You can only short up to a percentage of your long position. Suppose you are long on share A (undervalued) for 100. Then you short B (overvalued) for 20 and use it to buy additional undervalued shares (A or others or combination). Now your portfolio is 120/20. The reason for 20% short restriction is that short position has unlimited loss potential. But your long position has only limited loss potential.
So you equitize the short sale position by going long in a security what is overvalued, and this security doesn’t have to be one of your holdings on the long side. And the total return is the 100% long position + short alpha. Thanks for the explanations.
Equitize the short sale proceed by going long in an undervalued security (ies).
Short extension is in between long only and long-short (market neutral or not). Equitize short proceed with long in undervalued security (ies). McLeod81, I am not sure about your short alpha interpretation. I use CFA book and it says short alpha is from shorting overvalued shares that will decrease in value.