Anyone else confused by this? CFAI says - Short extension strategies : market return and alpha are generated from same source - Long / Short : goes short and long securities in the same industry and takes market exposure via derivatives
Makes sense… Long/Short mkt neutral strategy…pairs trade - two stocks in same industry…one long one short, systematic risk is offset and you are only left with unsystematic risk. Therefore, its a beta=0 strategy and only getting alpha. If you want to add beta, you use derivates. If that is the case, your benchmark becomes the derivative, whether it be an ETF or a futures. With a beta=0 strategy, your benchmark is the RFR.
McLeod had a really good explanation of this I think.
Quoting from Corrupted in another post - here is the link http://www.analystforum.com/phorums/read.php?13,965175,965175#msg-965175 Re: Short Extension Q Posted by: Corrupted (IP Logged) [hide posts from this user] Date: May 18, 2009 04:35PM Everyone is right, herding behavior? Your answer: A was incorrect. The correct answer was B) The market return and alpha for the short extension strategy are generated from the same source. In a short extension strategy the market return and alpha are generated from the same source – the market return comes from the long position in equities and the alpha comes from shorting those same overpriced/underperforming equities and using the proceeds to invest in undervalued securities. This is a disadvantage because it is more limiting and constraining as compared to the market neutral position which generates alpha by going long and short in under and overpriced securities respectively in the same industry and then using derivatives such as equity index futures to gain market exposure. Thus in the market neutral strategy the alpha and market exposure are gained from different sources. A disadvantage of a long only strategy is the constraint of only being able to reduce the weight of a poorly performing stock to zero in the portfolio. If the benchmark is market capitalized the effect on the portfolio is minimal for small and mid cap stocks. Conversely, a short extension strategy can short the same under performing small or mid cap stock in a greater proportion and exploit the negative information regarding the stock to a much larger degree than the long only strategy. A short extension strategy does not rely on the available liquidity of swaps and futures to gain market exposure as the market neutral strategy does.