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1、Part1. The main advantages and disadvantages of a long/short strategyA long/short equity strategy combines buying an undervalued stock and short selling an overvalued stock. When the long position outperforms the short positions, total return of this strategy is positive. The concept of long/short s
2、trategy could date back to 1949, when the worlds first hedge fund was established. And at present, long/short strategy is among the most prevalent strategies in this field. According to the way they hedge downside risk, long/short strategies could be grouped into three categories, and I would like t
3、o discuss main advantages and disadvantages of each category. 1. Make long and short direction bets based on fundamental researches.Buying securities which are supposed to rise in price while short-selling those that are supposed to decline in price. Basically, short position is used to generate add
4、itional returns. In practice, hedge fund managers use a variety of financial instrument such as index options, futures and ETFs to hedge downside risk, preventing the net exposure is too high.Main advantagesCompared with long-only investment, long/short strategy take advantage of those unattractive
5、securities. Provided expected security returns are symmetrically distributed around the market return, long/short takes full advantage of this spread of returns (Jacobs and Levy, 1996). Total excess return of a long/short equity portfolio comes from the long position and short position. Once the pri
6、ce of the short equity declined, the short position contributes a part of profit to the portfolio. In addition, by using long/short strategies, portfolio managers are able to neutralize underlying market risk. Experienced hedge fund managers tend to consider long and short position integrally, becau
7、se integrated optimization allows the portfolio to control risks more efficiently. For instance, the renewable energy stocks performances are negative correlated to the traditional coal and oil stocks. By longing one sector while short-selling another, at a limited risk level, investors can pursue h
8、igher returns. Main disadvantagesIf the manager wrongly predict directions, the losses could possibly be significant. Risk from long position is limited since the stock prices cannot be under zero; however, risk from short position is sometimes uncontrollable. When losses from short position offset
9、profit from long position, the strategy fails. Considering the efficiency of market, influence of investors behaviours, barriers and conflictions, the real securities prices are quite hard to predict. Stock markets tend to overreact and winner-loser effect widely exists (Debondt and Thaler, 1985). A
10、nd if a manager predicts and bets long/short directions based on an important event, the portfolio might lose money due to overreaction. If a manager predicts based on current price trend, the portfolio may also lose money in long run due to winner-loser effects.In conclusion, the performance of the
11、 first category long/short strategy heavily depend on the selection of stocks and hence the capability of portfolio managers. 2. Simply hedge long positions with ETFs or derivatives to reduce market risk.Managers selects a diversified portfolio of long stocks via fundamental analysis, and then hedge
12、 market risk with a synthetic short position, for example long put plus short call (relating stock index options).Main advantagesWhen the short opportunities are limited or short selling is restricted, this technique enables hedge fund manager to construct long/short portfolio. In practice, borrowin
13、g certain amount of one specific stock from brokers might be hard and expensive; moreover, in several financial markets (for example China) short-selling is heavily restricted. Given these facts, this strategy exhibits its great advantage that its practicable. And the initial investments of construc
14、ting short positions are comparatively low (differences of option premiums).In addition, to hedge out market risk, the direct and efficient way is constructing short position using index options. When the options are in-the-money, the profit from short position is linear to index changes.Main disadv
15、antagesThe short position may involve derivatives, which means the potential loss can be high. Portfolio managers have to control the amount of leverage in the long/short portfolio. Long put plus short call equals to short forwards. When the index rises significantly, considering the leverage, losse
16、s from short position is great, which might offset the profit from long position.3. Apply option-writing strategies, and sometimes may not even select stocks.For instance:Long position-holding a full diversified stocks portfolio, or index fund shares;Short position-selling index call options to make profit from the fluctuations in the market; meanwhile, long index put option to hedge the downside risks of market.Main advantagesThis strategy does not require much effort in selecting s
