Long-Short Alpha and other testable L3 material

In this super useful email we're going to describe earning two alphas with a long-short portfolio and related concepts that could be tested. We'll also throw in a few other concepts that could pop up randomly in a multiple choice context.

Long Short Strategies
Long-short strategies have the opportunity to earn two alphas whereas long-only positions can only earn one alpha. Both strategies share the opportunity to find undervalued stocks using fundamental analysis. The short side alpha opportunity, however, is about exploiting constraints that many investors face against selling stocks short.

Why Short Side Has Pricing Inefficiencies

· Barriers to entry (such as margin requirements)

· Firms are paid to promote stocks (investment banking activity) leading to fewer sell ratings

· Sell-side analysts also issue more buy signals than sell signals, maybe a result of wanting to keep access to management on firms they cover

Another advantage of the long-short strategy is that it can also pair its positions to create a market neutral position that eliminates systematic risk. A common example of this is to buy two stocks in the same industry: you buy the undervalued stock you expect to outperform and sell the weaker/overpriced stock. With the two stocks having approximately the same betas your overall beta, or market exposure, will be close to zero. Without systematic market exposure, the benchmark for a market neutral long-short strategy is the risk free rate.

For those of you who have bought our full notes, that's on p. 154. Be sure to know about Equitizing a Market-Neutral Long Short Portfolio (EMNLSP) which is right after that. If you don't have access yet you can get the full package at www.cfaexamlevel3.com.

Other Concepts:

Socially Responsible Investing
Socially Responsible Investing, SRI or ethical investing, uses social, moral, and/or ethical concerns to screen stocks. SRI screens can be positive, such as actively seeking out investments with positive characteristics (e.g. good labor practices) or negative, which entails avoiding stocks with unethical practices (avoiding tobacco is a common one).

SRI portfolios often tend to be biased towards tech and small-cap and tend to be underweight the energy sector

Management fees come in two forms. The first is ad valorem fees, which is just a fancy way to they are a management fee based on AUM. Management fees are straightforward and known in advance, but they do not align incentives between managers and investors.

Performance based fees on the other hand do align the incentives of managers and their investors. Performance based fees may be subject to caps as well as high-water marks and clawbacks (more on that in the alternatives section). Their disadvantage is that they (1) can be complicated and require detailed specification and (2) they increase the volatility of compensation for the manager which can make it difficult to retain staff

In general, the limited partner / general partner relatonship and the fee structures that govern them are a good example of how to try to align incentives to deal with the principal-agent problem.