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From Ron Surz: The financial press has recently reported favorably that some long-only managers have added short selling to their process. For example Chernoff [2005] identifies several traditional managers who are offering portfolios that are 130% long and 30% short, thereby maintaining a 100% net exposure. On its face this would appear to be a win-win: Net market exposure is unchanged, so risk is unchanged, but the manager can add value by selling short companies that he deems inferior. The realities however are that risk is indeed increased, even though traditional risk measures do not capture this fact*, and value is only added if the manager is right about his short selling picks. There is a new type of risk that is introduced by the switch from long only to long-short. We call this risk “implementation risk.” It results from the fact that 160% of your assets are exposed to the market – 130% long plus 30% short. This exposure increases opportunities and risk, but traditional measures of risk, namely return variability over time, do not reflect this increase.
To estimate implementation risk we use Monte Carlo simulations (MCS) that generate all of the possible implementations of the hedge fund manager’s strategy. In this way we can compare the opportunities for long-only to those for long-short. For a detailed description of MCS, see Surz [2005 & 2006]. Monte Carlo simulations are well-known to the alternative investments community. Randomly generated outcomes pr...................... To view our full article Click here
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