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A Mean-Variance Capital Asset Pricing Model for Long Short Equity

Hedge Fund Portfolios


David E. Hampton
Hedge Fund Sciences
http://www.hedgefundsciences.com
Email: david@hedgefundsciences.com

Abstract
In this paper a single factor mean-variance Capital Asset Pricing model is derived for long short
equity investment portfolios. This model is empirically tested using a statistical arbitrage
momentum trading strategy based on Dow Jones 30 historical equity data from 1986 to 2002. This
trading strategy commonly utilized in practice by hedge funds is typically classified as systematic
statistical arbitrage within the long short equity style. The equilibrium two moment model
developed has a desirable feature in that it is leverage invariant - a useful quality if used for long
short hedge fund performance measurement where leverage may be unknown, non-constant and
which may vary widely between various long short hedge fund portfolios making alpha estimation
difficult. Alpha is modeled as a function of beta using the concept of entropy as interpreted by
Shannon[13]. The two moment equations derived constitute a general equilibrium mean-variance
model and as such long only, short only and fractional beta long/short portfolios can be priced in the
CAPM sense. The approach taken is to assume that during the life of the investment, the overall
portfolio can be represented by the returns of the two sub-portfolios represented by long and short
positions via separation with a corresponding correlation coefficient. It is shown that the expected
portfolio return model agrees with the classical CAPM for expected portfolio return[14] in the theory
of market equilibrium under conditions of risk. The same analytical technique used for the first
moment model derivation is then used to derive the CAPM variance model. The validity of this
variance model is tested at the 95 per cent confidence level by empirically simulating a variable
fractional beta long short statistical arbitrage momentum trading strategy using Dow Jones 30 daily
equity price data from 1988 to 2002. The mean-variance model is then developed further in leverage
invariant equilibrium which leads to the formulation of an analytical dynamic alpha equation. As
this function can have a maximum value as a function of beta, the usual calculus techniques are used
to derive the analytical objective function which allows the determination of the optimal
mean-variance long short beta portfolio. Minimum existence conditions are then derived which
dictate the minimum pre-requisite performance expectations for the creation of a long/Short equity
portfolio for domination of the long only market index in the mean-variance sense. Finally, since
both the mean and variance expectation equations are derived, a stochastic differential equation is
formulated and the Black-Scholes option price derived.
Keywords: Mean, Variance, Long Short, Statistical Arbitrage, Capital Asset Pricing Model, Risk, Return,
Equity Hedge, Momentum, Leverage Invariant Performance Estimation, Optimal Beta Control, Equilibrium,
Existence Conditions, Entropy, Stochastic Differential Equation, Black-Scholes Option Pricing

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Electronic copy available at: http://ssrn.com/abstract=1071566

1
1.1

Introduction
Defining Long Short Equity Investment Space

Assumptions
1. There exist N risky equity securities and one risk-free security available for investment which are
liquid and tradeable either long or short in continuous time with zero trading costs and no cost
restrictions on either long or short positions.
2. Each equity is invested using 1/N amount of the available capital for any time t during the life of
the investment.
3. N is large enough so that at any one time the long and short sub-portfolio expected returns will be
approximately Gaussian on average if measured at medium term frequency(e.g. monthly or weekly).
4. Leverage is possible in the form of collateralization.
5. Information is assumed to exist which can be exploited by the portfolio manager to create either
alpha or alternative beta forms of alpha from trading or market timing of the underlying N
securities. The manager is assumed to be able to create any combination of the N securities, either
long or short, under the conditions of 1. and 2. above.
6. Long only, short only or long short positions can be generated at any time with only the N
underlying equities.
7. Cash equities are the only instruments assumed to exist for portfolio selection as well as the
risk-free security.
8. The N securities when held long with 1/N of the available wealth invested in each constitutes the
long only market portfolio.
Definitions
Definition 1.1 A Long short equity investment exists in long short investment space whenever there
are both long and short positions in a portfolio.
Definition 1.2 A long short equity hedge fund is an investment vehicle which is a long short equity investment, and which is managed for the pursuit of the generation of positive alpha returns or
alternative beta form of alpha returns and which may or may not be leveraged.
Definition 1.3 Trading is the process by which a manager actively creates various combinations of
long short portfolios on a regular basis e.g. daily, weekly or monthly.
Definition 1.4 Market timing describes the process by which the portfolio manager uses infrequent
decisions to trade the equities in the long term long short equity investment.
Definition 1.5 Alpha refers to the expected returns which can be attributed to portfolio manager equity
selection skill if positive and which are made possible by either trading or timing as defined.
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Electronic copy available at: http://ssrn.com/abstract=1071566

Definition 1.6 The long short equity portfolio (without leverage) space is bounded by integer beta
values of -1 and +1
1.0 < < 1.0
(1.1)
Proof: Assume the portfolio is long only and that there is no active trading of the risky assets. This
involves matching exactly the holdings of the risky assets to the holdings of the underlying market
index. As
cov(rp , rm )
=
(1.2)
m2
then due to the effect of matching the underlying holdings exactly, the correlation of returns of the
long only portfolio and the underlying market index will equal one. Hence
p,m =

Cov(rp , rm )
= 1.0
p m

(1.3)

it follows that
Cov(rp , rm ) = m p

(1.4)

and as
p = m
=

cov(rp , rm )
= 1.0
m2

(1.5)
(1.6)

Similarly, if the investor holds a short only portfolio, exactly matching the composition of the long
only market index, but in this case holding every risky asset short as opposed to long in exactly the
same proportions, then
Cov(rp , rm )
p,m =
= 1.0
(1.7)
p m
So
=

cov(rp , rm )
= 1.0
m2

(1.8)
QED

Long Short investment space therefore exists between these two extremes by definition of their
existence, hence
Proposition 1.7 The long short sub-portfolio separation theorem: If NL and by inference NS are
non-integer, then there exists two sub-portfolios at any one time - the long sub-portfolio and the short
sub-portfolio.

Long Short Portfolio Performance Expectations

The long short portfolio models as reviewed in the literature [9][5][2][7] do not tend to extend upon
the Capital Asset Pricing Model in long short equity investment space. Considering the importance
of the CAPM in investment pricing, this paper is an attempt to enlarge the concept of the CAPM
into the general setting of long short mean-variance investment space.
3

The key model derivation technique used in this paper hinges on using a linear substitution approach
between a measure of the the degree of longness of the portfolio L to the portfolios . The
technique is to firstly mathematically model the expected portfolio performance as a linear function
of L which is made possible by the fact that L can only take value between 0 and 1 and therefore
possesses the desirable quality of being a linear multiplicative operator on the independent model
variables. Since we assume a linear correspondence between L and , so the model equations
derived can also be estimated as functions of by direct substitution using the L / relationship.

2.1

Long Short Sub-portfolio Performance Estimation

The returns of each equally weighted long and short sub-portfolio can be measured as being the
average percentage return for the period considered for each security.
Definition 2.1 The long sub-portfolio expected return at time t
NL
1 X
E(rL , t) =
rL , i
NL

(2.1)

i=1

for NL equities chosen to be in the long sub-portfolio at any time t where 0 t


Definition 2.2 The short sub-portfolio expected return at time t
E(rS , t) =

NS
1 X
rS , j
NS

(2.2)

j=1

for NS equities chosen to be in the short sub-portfolio at any time t where 0 t


under the condition
NL + NS = N

(2.3)

Definition 2.3 The long sub-portfolio expected return over the total return period of measurement
E(rL ) =

E(rL , t)

(2.4)

t=0

for t, where 0 t
Definition 2.4 The short sub-portfolio expected return over time period
E(rS ) =

E(rS , t)

(2.5)

t=0

for t, where 0 t
Definition 2.5 The long short equity portfolio expected return
E(rp ) = E(rL ) + E(rS )

(2.6)

Definition 2.6 The correlation coefficient between the long and short sub-portfolio returns over time
is
Covar(rL , rS )
=
(2.7)
V ar(rL )V ar(rS )
Proposition 2.7
= 2L 1
where
=

Cov(rp , rm )
V ar(rm )

(2.8)
(2.9)

and where L is the longness of the long short portfolio under the constraint that
L + S = 1.0

(2.10)

L = NL /N

(2.11)

0 L 1

(2.12)

NL + NS = N

(2.13)

where
and
and
Proof:
As covariance satisfies the properties of an inner product, for constants a and b and random
variables X, Y and U
Cov(aX + bY, U ) = aCov(X, U ) + bCov(Y, U )

(2.14)

and since
E(RL ) = E(RS )

(2.15)

V ar(RL ) = V ar(RS )

(2.16)

Cov(rp , rm ) = Cov(L rL + (1 L )rL , rm )

(2.17)

Cov(rp , rm ) = L Cov(rL , rm ) + (1 L )Cov(rS , rm )

(2.18)

Cov(X, X) = V ar(X)

(2.19)

Cov(rp , rm ) = L V ar(rm ) (1 L )V ar(rm ) = (2L 1)V ar(rm )

(2.20)

Cov(rp , rm )
= = 2L 1
V ar(rm )

(2.21)

and
So

Since

so

thus

QED

Modelling Alpha in Long Short Space

The approach to modelling the alpha availability as a function of beta in this paper is based on the
the notion of entropy being equivalent to the available degrees of freedom of choice available in
choosing the various long and short positions as a function of longness. The notion of entropy was
developed by Shannon[13] for binary information transmission systems based on initial insights by
Boltzmann.
Proposition 3.1
(L ) = 3.32M N (L log L1 + (1 L ) log(1 L )1

(3.1)

() = 1.66M N ((1 + ) log 2(1 + )1 + (1 ) log 2(1 )1

(3.2)

= 2 L 1

(3.3)

Proposition 3.2

as

Empirical studies were performed to validate the above expression using artificial price data with
known information structure in its conditional time series returns i.e. positive significant
autocorrelation. These time series which were designed not to have a drift rate during the examined
period of time and which had similar volatilities, were simulated in long short configurations using
the momentum trading model. The actively generated alphas available as a function of beta are
shown in Figure 2.0 and agree well with the entropy equation proposed.
Assume for the remainder of this paper however that alpha is a fixed amount that does not fluctuate
with beta and that it can be estimated as the amount of estimated alpha associated with the market
neutral special case. For empirical studies the market neutral alpha is readily measurable from a
selection of available market neutral strategies performance measures. However, the fact that alpha
is also a function of beta requires an iterative technique for solution which is beyond the scope of
this paper.

Modelling the Risk Free Rate in Long Short Space

To correctly model the expected return on investment from a long short strategy, it is important to
correctly model the degree of risk free rate available as a function of L , and subsequently of as it
plays an integral part in the return expectation.
Proposition 4.1
RFA = (1 )rf

(4.1)

Proof: Let RFA be the risk free rate available for any given L or . Assume
RFA = RFL + RFS

(4.2)

where RFL is the available risk free return available from the long positions, and RFS is the available
risk free return available from the short positions. is the total capital available for allocation to the
long short strategy, and assuming no leverage, it follows that
( L )rf
= (1 L )rf

(4.3)

(1 L )rf
( L )rf
=
= (1 L )rf

(4.4)

RFL =
RFS =
Thus

RFA = 2(1 L )rf = (1 )rf

(4.5)
QED

This risk free rate availability relationship for excess capital can be argued as follows. Assume there
is 10 million USD of funds to allocate to a long short equity strategy. In the long only case the
investor will allocate all funds to long positions so there will be no capital left for investing at the
additional risk free rate. In the case of a long short strategy with L =0.75 and =0.5, USD 7.5 M
will be allocated to long positions, and USD 2.5 M will be allocated to short positions. This leaves
an excess long side amount of USD 2.5 M, which when added to the USD 2.5 M short rebate leaves
the investor USD 5 M for investment at the risk free rate. In the case of a market neutral strategy
where L =0.5 and =0, the investor will allocate USD 5 M to long positions, and create a USD 5 M
portfolio of short positions. This will amount to an excess long side amount of USD 5 M, which
when added to the USD 5 M short sale rebate leaves the investor USD 10 M or investment at the
risk free rate. In the case of a short long strategy where L =0.25 and =-0.5, the investor will
allocate USD 2.5 M to long positions, and create a USD 7.5 M portfolio of short positions. This will
amount to an excess long side amount of USD 7.5 M, which when added to the USD 7.5 M short sale
rebate leaves the investor USD 15 M or investment at the risk free rate. Finally, for the short only
case the investor will allocate USD 0 M to long positions, and create a USD 10 M set of short
positions. This will amount to an excess long side amount of USD 10 M, which when added to the
USD 10 M short sale rebate leaves the investor USD 20 M for investment at the risk free rate. The
amounts of capital available predicted using the above argument, assuming no leverage, is seen to
agree with the model as derived.

Expected Capital Asset Returns in Long Short Space

At the foundation of the traditional CAPM model lies the concept of two mutually exclusive sources
of return, the and the .
Definition 5.1 is the component of the long short portfolio returns as previously defined
= L L + (1 L )S

(5.1)

where L is the alpha generated from the long positions and S is the alpha generated from the short
positions. The total alpha is therefore seen to contain two sources of additive underlying alpha
associated with the two sub-portfolios leading to the long short equity technique being commonly labelled
as a double-alpha strategy.
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Definition 5.2 is the correlation of the long short portfolios return to that of the N long only
portfolio
Cov(rp , rm )
=
(5.2)
V ar(rm )
where
0.0 1.0

(5.3)

E(rp ) = + rm

(5.4)

= L L + (1 L )S

(5.5)

Proposition 5.3

Proof: Since
and considering the expected total return available for both the long and short positions in terms of
their alpha and beta components
E(RL ) = L L + L rm = L (L + rm )

(5.6)

E(RS ) = (1 L )S (1 )rm = (1 L )(S rm )

(5.7)

E(rp ) = E(rL ) + E(rS )

(5.8)

as for N risky assets


E(rp ) =

N
1 X
i ri
N

(5.9)

i=1

Thus
E(rp ) = L (L + rm ) + (1 L )(S rm ) = (2L 1)rm + L L + (1 L )S

(5.10)

From (5.5)
E(rp ) = + (2L 1)rm = + rm

(5.11)
QED

Definition 5.4  is the component of portfolio returns generated that cannot be explained by the other
dependent variables i.e.  represents a Gaussian noise component.

5.1

The Long Short Portfolio Expected Return Equation

It has been asserted that under the restrictive assumptions of the single factor Capital Asset Pricing
Model i.e. Gaussian return expectations or quadratic utility preferences, that the total expected
return of the long short portfolio is a linear combination of four factors - the risk free rate available
RFA , manager skill based abnormal returns , returns associated with the underlying long only
market index return by a correlation coefficient , and a Gaussian noise component .
Proposition 5.5 The Expected Long Short Portfolio returns are
E(rp ) = + E(rm ) + (1 )rf + 
8

(5.12)

It can be seen that on rearranging, the equation becomes

E(rp ) rf = + (E(rm ) rf ) + 

(5.13)

which is equivalent to the traditional Sharpe CAPM[14]. The expected return from an un-leveraged
long short equity strategy with the traditional CAPM assumption properties is therefore equivalent
in form to the traditional long only equity CAPM as developed by Sharpe.

The Long Short Portfolio Variance Model

Having applied the previous linear long short pricing technique using the L / substitution technique
as a successful means of deriving a CAPM for the portfolio expected return for long short equity which
matches the original Sharpe solution, the same technique will now be applied in an attempt to derive
the long short CAPM variance equation. As before, the expected properties of the long and short
positions will be derived separately, then combined together into the expected variance equation for
the portfolio. The L / substitution technique will then be used to define the portfolio variance as a
function of the portfolios beta.

6.1

Model Derivation

Proposition 6.1 The Second Moment Variance equation for long short statistical arbitrage portfolios
is as follows
( 2 1)(1 )
r2p = r2m {
+ 1}
(6.1)
2
p
And since the portfolio volatility x = x2 the volatility model for long short equity under the model
assumptions of this paper is therefore
r
( 2 1)(1 )
p = m
+1
(6.2)
2
Proof: Assuming no alpha generation possible, the volatilities of the portfolio long and short returns
can be expressed as linear functions of the market volatility using the L multiplier as
L = L m

(6.3)

S = (1 L )m

(6.4)

From Markowitz [8]


p2

N X
N
X

i j Cov(rij )

(6.5)

i=1 j=1

Since
Cov(XY ) = X Y XY

(6.6)

it follows for N risky assets in a portfolio that


p2 =

N X
N
X
i=1 j=1

i j i j ij

(6.7)

Hence for the long and short returns of the portfolio


p2 = L2 + S2 + 2L S

(6.8)

where is the average correlation coefficient between the long side and short side returns of the
portfolio assuming
NL
X
E(rL ) =
wi ri
(6.9)
i=1

E(rS ) =

NS
X

wi ri

(6.10)

i=1

E(rp ) = E(rL ) + E(rS )


thus

(6.11)

Cov(rL , rS )
L S

(6.12)

1.0 1.0

(6.13)

p2 = (L m )2 + [(1 L )m ]2 + 2L m (1 L )m

(6.14)

=
where
Hence
Therefore

2
2
2
p = (L2 m
+ (1 L )2 m
+ 2L m
(1 L )) 2
1

= m (L2 + (1 L )2 + 2L (1 L )) 2
= m (2L (L 1)(1 ) + 1)

1
2

(6.15)
(6.16)
(6.17)

As L = 21 ( + 1) and assuming that any alpha volatility is accounted for in the long short portfolio
volatility model it follows from substitution and further simplification that
r
( 2 1)(1 )
p = m
+1
(6.18)
2
Hence
2
r2 = m
{

( 2 1)(1 )
+ 1}
2

(6.19)
QED

It can be seen that this equation q


represents a linear Capital Asset Pricing model for expected
2
volatility, where the slope factor ( 1)(1)
+ 1 is non-linear with respect to .
2

Empirical Tests of the Volatility Model

To test the volatility model proposed, it was decided to use historical backward adjusted stock data
for the Dow Jones 30 index from 1986 to 2003. The data as adjusted for splits and any dividends were
re-invested in their companys stock.
10

7.1

Testing for Expected Volatility using Momentum Trading Strategies

The statistical arbitrage portfolio model lends itself readily to empirical testing of the long short
mean variance model as presented in this paper. The statistical arbitrage model can be implemented
as a momentum model[6]. A momentum strategy is defined by the triplet (J, S, K), where J is the
ranking period (according to past J days cumulative returns), S is a skip period (set to one day
ahead for the purposes of this test) and K is a holding period (allowed to vary each day according to
new trading signals as they are generated from the ranking algorithm). Each day using the Dow
Jones cross sectional data set, stocks were sorted according to their relative ranking of average
historical returns over J previous days. Long short portfolios were formed by shorting stocks in the
top T percentile of the ranked set and by longing stocks in the bottom B percentile of the ranked
set. All stocks between the top and bottom percentile were left in their previous long or short state.
This technique can be seen to exploit short-term mean reversion tendencies of equity markets using
relative ranking[10]. This strategy is commonly used as a means of exploiting predictable
self-information in historical stock prices by statistical arbitrage managers. This particular style fits
well with the limited assumptions of the model as proposed, and can be classed as a special form of
long short equity strategy.

7.2

Validity of the Volatility Model

The assumption of this test is that the markets under investigation i.e. the Dow Jones 30 is efficient
in the semi-weak form proposed by Fama[3]. In assuming this to be the case, there should be no
alpha generated by the momentum trading strategy in any persistent fashion for any combination of
its three triplet variables. The Dow Jones 30 is indicative of a stock index holding many highly
followed, public companies and as such, is representative of the kind of stock market holding whose
constituent companies are priced efficiently by the market[11].
Long short volatility was modeled using the previously derived equation
r
( 2 1)(1 )
+1
p = m
2

(7.1)

The results as presented in the figures show that for three cases of long/short equity formation, there
is a close relationship between the the estimated portfolio volatility and that measured. This
closeness of forecast versus measured correlation is sufficient evidence to support the validity of the
model as accounted for by high coefficients of determination for each regression. As a second source
of evidence that the model is satisfactory, a hypothesis test was performed for each year in the
sample period for of the three Long Short configuration strategies presented.The hypothesis test was
formulated as
2
2
H0 : measured
= f2orecast versus H1 : measured
6= f2orecast
(7.2)
The suitable test statistic for testing the equivalence of two volatility estimates is the F-test
F =

S1
S2

(7.3)

The results were validated at the 95 percent confidence level in the tables as shown. For all of the
years simulated and for both J=5 and J=15, it was not possible to reject the null hypothesis that the
measured volatility was equivalent to the forecast volatility. The volatility model is thus acceptable
11

with validity at the 95 per cent level of confidence. Figure 9.0 shows that there is a significant
relationship between J and the alpha generated in market neutral configuration, whilst figure 10.0
demonstrates that there is no particular reason for suspecting an associated significant increase in
volatility after accounting for the any absolute alpha.

A Risk Adjusted Return Model for Long Short Equity Portfolios

We assume that the portfolio returns are approximately Gaussian - a non-naive assumption for long
short equity hedge fund strategies due to the mixing of opposite higher co-moments eg. positive and
negative skewness in the long and short sub-portfolios. This mixing effect leads to an overall
cancelation effect in the final portfolio for higher co-moments under the assumptions proposed.
The information ratio is defined as the quotient of the first two moments of the portfolio return
distribution. Since it captures the leverage invariant nature of investment performance, it was chosen
as the appropriate measure for leverage invariant equilibrium performance pricing[4].
Definition 8.1 The Information Ratio
=

8.1

E(rp )
p

(8.1)

Leverage Invariant Long Short Equity Capital Asset Pricing Equilibrium

From the return and volatility expressions derived in this paper, the Information ratio can be
expressed as
+ E(rm ) + (1 )rf + 
E(rp )
q
=
2
p
m ( 1)(1)
+1
2

(8.2)

The following equilibrium condition follows directly


Proposition 8.2
r
E(rp )m

( 2 + 1)(1 )
+ 1 = p + p E(rm ) + p (1 )rf
2

(8.3)

This equilibrium condition makes it possible to derive any one variable estimate in the identity if the
other variables are quantifiable.

8.2

Implied Equilibrium Leverage Invariant Alpha Estimation

A common requirement for analysis of long short performance data is to dynamically estimate the
amount of alpha generated by a particular long short manager or strategy. From the long short
mean-variance equilibrium identity developed, implied alpha can be calculated.
For the general long short case the implied alpha is

12

Proposition 8.3
imp

E(rp )
= E(rf rm ) +
(m
p

( 2 + 1)(1 )
+ 1) rf
2

(8.4)

For the special market neutral case when beta is zero, the implied alpha is
Proposition 8.4
impM N

E(rp )
=
m
p

(1 + )
rf
2

(8.5)

The implied alpha derived is leverage invariant and can be dynamically estimated over time. Being
leverage invariant is a useful property as very often leverage is not constant and tends to vary
significantly between various long short equity hedge fund investments.

The Optimum Mean Variance Long Short Portfolio Beta

Proposition 9.1 There may exist for certain combinations of variables within the model as derived
an optimal long short portfolio beta where 0 < < 1. This beta value is the optimum beta for the
long short equity portfolio in the mean-variance sense as it represents the beta associated with the
optimum information ratio.
Proposition 9.2
=

(E(rm ) rf )(1 + )
( + rf )(1 )

(9.1)

Proof: The information ratio as a function of beta is a continuous function, differentiable everywhere
where 0 1 and is either convex or bounded by a greater value of beta associated with passive
long or short investing as is seen in Figure 9.0 for a particular set of values. Differentiation of the
long short information ratio with respect to beta and setting the result equal to zero is therefore the
necessary and sufficient condition for locating a global maximum stationary point.
d
=0
(9.2)
d
Using the chain rule within the quotient rule and setting the result equal to zero in order to identify
the conditions corresponding to the stationary point as sought, yields the following result
1

d
=
d

m (E(rm ) rf ) ( 12 ( 2 1)(1 ) + 1) 2 ( + E(rm ) + (1 )rf )


( 12 ( 2 1)(1 ) + 1)

1
(1)
2 m
1
1
2
( 2 ( 1)(1)+1) 2

=0
(9.3)

On simplification and rearranging the variables as a function of , the following identity emerges
(E(rm ) rf )(1 + )
(9.4)
( + rf )(1 )
This objective function is the optimum long short portfolio beta in the sense that it will represent
the portfolio which will dominate all other long short beta portfolios in mean-variance space. QED
=

13

The optimal longness can then be calculated as


1
1 (E(rm ) rf )(1 + )
L = ( + 1) = {
+ 1}
2
2
( + rf )(1 )

(9.5)

S = 1 L

(9.6)

1 < L < 1

(9.7)

0 < < 1

(9.8)

and

where
and

10

Minimum Conditions for Long Short Equity Hedge Fund Existence

Proposition 10.1
>

(E(rm ) rf )(1 + )
rf
(1 )

(10.1)

This identity defines the minimum equilibrium value of implied alpha for which a long short portfolio
should exist in the mean-variance domination sense of the market portfolio, all other terms held
constant. If this minimum condition for alpha is not met, a long short portfolios existence cannot be
justified.
Proposition 10.2
<

E(rm ) + 2rf
+ E(rm )

(10.2)

This identity allows the calculation of the maximum equilibrium value of for which a long short
portfolios existence can be justified. If this condition for does not hold, then only the long only
market portfolio is justified in providing the optimum risk adjusted returns portfolio.
Proof: These results follows directly from the optimal beta proposition, under the condition that
the < 1.0 which by definition is the property required of the leverage invariant portfolio whose
existence is warranted due to its higher information ratio (by definition of being a maximum) having
a beta different from the market portfolio. These are therefore the minima conditions required for
alpha and rho if a long short equity portfolio is to dominate the long only 1/N index portfolio in
mean-variance investment space.
QED

14

11

Stochastic Differential Equation Performance Modeling

Since two moments have been derived for the long short equity model, this facilitates modelling the
equations in time using the two moment Gaussian stochastic differential equation (SDE) as
developed by Wiener

S
= t +  t
S

(11.1)

= E(rp ) = + E(rm ) + (1 )rf + 

(11.2)

where

and
r
= m

( 2 1)(1 )
+1
2

(11.3)

Since we are dealing with one dimensional stochastic Brownian motion for a long short equity
investment portfolio, S can be thought of as being the initial value of the investment. S will
therefore measure the change in the value of the investment over the time interval t. The estimates
of the first two moments allow the simulation of performance over future time periods and facilitates
confidence interval estimation for future investment performance.

12

Risk-Neutral Option Pricing

The SDE developed in the previous section is the basis for the derivation of the Black-Scholes option
pricing formula. Since the framework of risk-neutral valuation is used for the derivation, the first
moment or expected mean return of the long short equity portfolio becomes insignificant since an
investor is risk-adverse due to the assumption of continuous delta hedging. As such, the investor will
earn the risk free rate in the risk-neutral framework and the following Black-Scholes option pricing
formula results.
C = N (d1 )Se(T t) N (d2 )K

(12.1)

where N (d1 ) and N (d2 ) are the cumulative normal distribution functions of d1 and d2 , where

d1 =

log(S/K) + (r + 2 /2)(T t)

T t

and

15

(12.2)


d2 = d1 T t
d1 =

log(S/K) + (r + 2 /2)(T t)

T t

(12.3)

(12.4)

where
r
= m

( 2 1)(1 )
+1
2

(12.5)

and
C = value of the call, t = current time, T = expiration date, S = current value of the long short
portfolio, K = strike price of the option, r = risk-free rate of interest, = the volatility of the long
short investment portfolio.
The option price of a call or put can thefore be calculated for the long short equity portfolio with
estimated portfolio volatility .

13

Concluding Remarks

Under the restrictive assumptions and definitions as introduced, capital asset pricing model
equations have been derived for both the expected mean return and variance for long short equity
hedge fund portfolios as defined. The generality of long short space as introduced implies that the
long only, short only and market neutral strategies may be modelled as special cases. An interesting
finding was that the expected mean return equation was identical in form to the CAPM as developed
by Sharpe[14] in his theory of market equilibrium under conditions of risk. The long short portfolio
variance equation which was developed using the same technique was verified empirically as being
correct at the 95 per cent level of confidence using the momentum trading strategy simulated on the
Dow Jones 30 component equities using daily historical data from 1986 to 2002.
The alpha available as a function of beta was modelled using the interpretation of entropy as
developed by Shannon[13]. This innovation which was tested using data with embedded information
was shown to hold under the restrictive assumptions of the model as described. Due to computation
difficulties of having an alpha term which is a function of beta, the alpha is assumed to be beta
invariant for the remainder of the paper to facilitate the development of further theoretical notions.
This assumption can easily be relaxed be relaxed for computational purposes as an initial estimate of
market neutral alpha can be measured from readily available market neutral manager data or
simulation. Thence an iterative process could be used to adjust the alpha available as a function of
beta.
Since any leverage employed increases expected returns proportionally to the leverage, so too the
volatility of the portfolio will increase by the same percentage amount since an increase in expected
return must be accompanied by an increase in volatility, both of which are directly proportional to
the extent of leverage applied to the long short portfolio. As a direct result, in order to correctly
appraise the performance of long short equity portfolios which may employ differing amounts of
16

leverage, a leverage invariant performance estimation technique must be used. As the information
ratio possesses the property of leverage invariance as leverage will affect the numerator and
denominator similarly by definition, the mean variance equations as derived were expressed in
equilibrium form as information ratios. This approach was then used to derive an equilibrium based
estimate of leverage invariant implied alpha.
It was shown that for various estimates of alpha, the expected information ratio of the long short
portfolio as a function of beta was non-linear due to the existence of a stationary maximum point.
Differentiating the information ratio function as a function of beta and setting the answer equal to
zero yielded an interesting result which makes the calculation of the optimal beta portfolio possible
at any time if alpha, the risk free rate, the expected return on the market market portfolio and the
correlation between the long and short sub-portfolios are known. If these independent variables can
be estimated dynamically, this implies that a manager could dynamically tilt the longness of the long
short equity portfolio to hold the optimal portfolio in the mean variance sense. This finding may
lead to a useful application for optimal control theory for long short equity portfolios. For the
optimal beta control function derived, it was noted that neither the volatility of the long short
portfolio nor the volatility of the market portfolio were of importance in the calculation of its value.
Since under the arguments of rational investors, a long short portfolio should only exist if it can
dominate the long only market portfolio in mean-variance space, so the optimal beta equation also
allows the derivation of minimum existence conditions for the four independent variables mentioned
above. This is due to the implication that the information ratio as a function of beta possesses a
maximum turning point that is greater than the information ratio for the long only market portfolio
and so must possess a beta which is less than one. The minimal existence criteria are then derived
for alpha and the correlation coefficient between the long and short sub-portfolios. The importance
of the correlation coefficient in the equations derived highlights the fact that a long short correlation
benchmark is important for informed estimation of manager performance within the long short
equity hedge fund asset class.
The SDE commonly used for asset pricing assuming Brownian motion and iid returns was modelled
using the expected return and volatility equations derived. Such a model allows portfolio value
expectations to be estimated with confidence in future time periods. Similarly value-at-risk (VaR)
can be estimated for performance control and risk budgeting implemented.
Since the SDE is the basis of the Black-Scholes[1] risk-neutral option pricing formula, so the
volatility and variance equations can be substituted directly into this formula to allow the values of
vanilla call and put options to be estimated. This pricing mechanism may help facilitate the
development of a liquid underlying derivatives market for this class of investment product for use
with dynamic portfolio insurance techniques.

17

References
[1] Fischer Black, Myron Scholes The Pricing of Options and Corporate Liabilities Journal of
Political Economy, 81 (May-June):637-54, 1973.
[2] John S. Brush. Comparisons and Combinations of Long and Long/Short Strategies Financial
Analysts Journal. , p 81, May/June 1997.
[3] Eugene Fama. A Theory of Market Prices The Journal of Finance. , 22, pp 27-59, 1958.
[4] Thomas H. Goodwin. The Information Ratio Financial Analysts Journal, July-August 1998.
[5] Bruce I. Jacobs, Kenneth N. Levy, David Starer Long-Short Portfolio Management: An Integrated Approach The Journal of Portfolio Management. p 23, Winter 1999.
[6] Robert A. Korajczyk, Ronnie Sadka Are Momentum Profits Robust to Trading Costs The
Journal of Finance,Vol LIX, p 1039, June 2004.
[7] Andrew W. Lo, Pankaj N. Patel 130/30: The New Long-Only The Journal of Portfolio
Management, p 12, Winter 2008.
[8] Harry Markowitz. Porfolio Selection The Journal of Finance, p77 , 1955.
[9] Richard O. Michaud. Are Long-Short Equity Strategies Supior? Financial Analysts Journal, p
44, November-December 1993.
[10] J.M. Poterba, L.H. Summers Mean Reversion in Stock Prices The Journal of Financial Economics, 22, pp 27-59 1988.
[11] Paul Samuelson. Why Stock Market Prices Must Fluctuate Randomly The Journal of Finance,
22, pp 27-59, 1973.
[12] Stephen E. Satchell, Christian S. Pedersen On the Foundation of Performance Measures under
Asymmetric Returns University of Cambridge working paper, 2002.
[13] Claude E. Shannon A Mathematical Theory of Communication, 1948
[14] William F. Sharpe. Capital Asset Prices: A Theory of Market Equilibrium under Conditions of
Risk The Journal of Finance. , Vol XIX, p 425, September 1964.
[15] William F. Sharpe. The Sharpe Ratio Wiley, 1974.

18

E[R p]
Beta=-2

Beta=2
1X0/Y0
Long/Short Space

1X0/Y0
Short/Long Space
Beta=-1

Beta=1

Long/Short Space
Short/Long Space
Market Neutral

Market Neutral

Short/Long Space

Long/Short Space

E[R m]

Beta=-1

Beta=1
Beta=-2

Beta=2

1X0/Y0
Long/Short Space

1X0/Y0
Short/Long Space

Figure 1: Long short investment space with the special cases shown of integer beta portfolios corresponding to market neutral, passive long or short only cases with varying degrees of leverage.

Alpha as a Function of Beta


90

80

70

60

MA 4 H=0.6
MA 10 H=0.6
MA 1 H=0.6
Fitted Relationship

Alpha

50

40

30

20

10

-1.00

-0.80

-0.60

-0.40

-0.20

0
0.00

0.20

0.40

0.60

0.80

1.00

Beta

Figure 2: Alpha availability as a function of Beta - theoretical proposition and the empirical evidence.
The equation proposed is of the same form as the Shannon entropy relationship.

19

Year
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002

Measured
Measured Measured
Measured
Forecast
Mkt Sigma % L/S Correl
Beta
HF Sigma % HF Sigma %
12,29
-0,87
0,09
3,40
3,80
13,65
-0,79
-0,31
6,16
6,41
21,50
-0,88
-0,12
5,63
6,21
17,32
-0,70
0,10
7,81
7,35
9,46
-0,52
0,09
5,32
5,21
8,61
-0,40
0,12
5,86
5,31
10,90
-0,73
0,10
4,25
4,65
5,21
-0,02
-0,16
5,55
4,19
11,06
-0,83
-0,19
4,13
4,30
18,47
-0,82
0,01
5,98
6,10
21,57
-0,84
-0,06
6,19
6,68
13,33
-0,36
0,05
9,78
8,06
16,20
-0,43
0,04
8,72
9,14
21,32
-0,67
0,11
8,38
9,43
26,10
-0,86
-0,11
6,19
7,99

Average
Standard Deviation

15,13
5,65

-0,65
0,24

-0,02
0,13

6,22
1,72

Forecasting
Error
0,40
0,25
0,57
-0,46
-0,11
-0,55
0,40
-1,36
0,16
0,11
0,49
-1,72
0,41
1,05
1,80

6,32
1,73

0,10
0,84

H Test
Reject Ho Y/N
N
N
N
N
N
N
N
N
N
N
N
N
N
N
N
N

Table 1: Forecast and Measured Volatility and Risk Reduction for J=5, Market Neutral.

Forecast vs Measured Portfolio Volatility in %


20,00

18,00

16,00

14,00

Forecast

12,00

10,00

8,00

6,00

4,00

2,00

0,00
0,00

2,00

4,00

6,00

8,00

10,00

12,00

14,00

16,00

18,00

20,00

Measured

Figure 3: Forecast and Measured Volatility Scatter Plot for J=5, Market Neutral r2 = 0.77.

20

Year
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002

Measured
Measured Measured
Measured
Forecast
Mkt Sigma % L/S Correl
Beta
HF Sigma % HF Sigma %
12,29
-0,76
0,61
7,83
8,68
13,65
-0,63
0,39
7,26
8,12
21,50
-0,82
0,42
10,02
11,29
17,32
-0,61
0,59
11,69
12,47
9,46
-0,67
0,57
6,04
6,79
8,61
-0,38
0,58
6,32
6,81
10,90
-0,81
0,53
6,03
6,93
5,21
-0,01
0,48
5,12
4,58
11,06
-0,74
0,28
4,86
5,43
18,47
-0,93
0,39
7,30
8,30
21,57
-0,82
0,40
9,72
11,00
13,33
-0,69
0,55
8,12
9,05
16,20
-0,20
0,65
12,79
13,63
21,32
-0,66
0,44
11,20
12,78
26,10
-0,89
0,41
10,95
12,54

Average
Standard Deviation

15,13
5,65

-0,64
0,25

0,49
0,10

8,35
2,46

Forecasting
Error
0,85
0,86
1,28
0,78
0,75
0,49
0,90
-0,54
0,57
1,00
1,28
0,93
0,84
1,58
1,59

9,23
2,78

0,88
0,49

H Test
Reject Ho Y/N
N
N
N
N
N
N
N
N
N
N
N
N
N
N
N
N

Table 2: Forecast and Measured Volatility and Risk Reduction for J=5, Long Short = 0, 5.

Forecast vs Measured Portfolio Volatility in %


20,00

18,00

16,00

14,00

Forecast

12,00

10,00

8,00

6,00

4,00

2,00

0,00
0,00

2,00

4,00

6,00

8,00

10,00

12,00

14,00

16,00

18,00

20,00

Measured

Figure 4: Forecast and Measured Volatility Scatter Plot for J=5, Long Short = 0.5, r2 = 0.99.

21

Year
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002

Measured
Measured Measured
Measured
Forecast
Mkt Sigma % L/S Correl
Beta
HF Sigma % HF Sigma %
12,29
-0,80
-0,52
7,03
7,73
13,65
-0,86
-0,68
9,39
10,22
21,50
-0,89
-0,64
13,37
14,70
17,32
-0,92
-0,66
11,56
12,22
9,46
-0,66
-0,46
5,53
6,05
8,61
-0,55
-0,56
5,72
6,41
10,90
-0,66
-0,61
7,13
8,07
5,21
0,53
-1,31
10,14
6,14
11,06
-0,69
-0,86
9,66
10,27
18,47
-0,73
-0,92
16,78
17,63
21,57
-0,84
-0,67
14,83
15,59
13,33
-0,65
-0,78
10,77
11,48
16,20
-0,50
-0,46
9,17
10,88
21,32
-0,42
-0,63
14,44
16,63
26,10
-0,81
-0,52
13,77
15,72

Average
Standard Deviation

15,13
5,65

-0,63
0,34

-0,69
0,21

10,62
3,35

Forecasting
Error
0,69
0,83
1,33
0,66
0,52
0,70
0,94
-4,00
0,61
0,84
0,77
0,71
1,71
2,19
1,95

11,32
3,85

0,70
1,35

H Test
Reject Ho Y/N
N
N
N
N
N
N
N
N
N
N
N
N
N
N
N
N

Table 3: Forecast and Measured Volatility and Risk Reduction for J=5, Long Short = 0, 65.

Forecast vs Measured Portfolio Volatility in %


20,00

18,00

16,00

14,00

Forecast

12,00

10,00

8,00

6,00

4,00

2,00

0,00
0,00

2,00

4,00

6,00

8,00

10,00

12,00

14,00

16,00

18,00

20,00

Measured

Figure 5: Forecast and Measured Volatility Scatter Plot for J=5, Long Short = 0.65, r2 = 0.95.

22

Year
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002

Measured
Measured Measured
Measured
Forecast
Mkt Sigma % L/S Correl
Beta
HF Sigma % HF Sigma %
12,29
-0,95
0,17
2,78
3,35
13,65
-0,77
-0,27
5,94
6,25
21,50
-0,90
-0,09
5,24
5,60
17,32
-0,80
0,04
7,08
5,96
9,46
-0,64
-0,02
4,54
4,50
8,61
-0,56
0,15
4,66
4,71
10,90
-0,82
-0,14
3,66
4,12
5,21
-0,23
-0,15
4,14
3,79
11,06
-0,67
-0,35
6,22
6,21
18,47
-0,83
-0,04
5,97
5,96
21,57
-0,81
0,13
6,96
7,77
13,33
-0,61
-0,21
7,34
6,87
16,20
-0,61
0,05
6,93
7,71
21,32
-0,68
0,00
8,04
9,03
26,10
-0,91
-0,11
5,00
6,78

Average
Standard Deviation

15,13
5,65

-0,72
0,17

-0,05
0,15

5,63
1,46

Forecasting
Error
0,57
0,31
0,35
-1,12
-0,04
0,05
0,46
-0,35
-0,01
-0,02
0,81
-0,47
0,78
0,99
1,77

5,91
1,55

0,27
0,67

H Test
Reject Ho Y/N
N
N
N
N
N
N
N
N
N
N
N
N
N
N
N
N

Table 4: Forecast and Measured Volatility and Risk Reduction for J=15, Market Neutral.

Forecast vs Measured Portfolio Volatility in %


20,00

18,00

16,00

14,00

Forecast

12,00

10,00

8,00

6,00

4,00

2,00

0,00
0,00

2,00

4,00

6,00

8,00

10,00

12,00

14,00

16,00

18,00

20,00

Measured

Figure 6: Forecast and Measured Volatility Scatter Plot for J=15, Market Neutral r2 = 0.82.

23

Year
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002

Measured
Measured Measured
Measured
Forecast
Mkt Sigma % L/S Correl
Beta
HF Sigma % HF Sigma %
12,29
-0,71
0,66
8,44
9,37
13,65
-0,77
0,41
6,61
7,54
21,50
-0,88
0,41
9,55
10,50
17,32
-0,82
0,57
10,30
11,24
9,46
-0,64
0,49
5,68
6,28
8,61
-0,04
0,72
7,95
7,96
10,90
-0,92
0,48
5,25
6,03
5,21
-0,26
0,39
4,06
4,07
11,06
-0,74
0,25
4,83
5,25
18,47
-0,86
0,67
12,34
13,48
21,57
-0,61
0,70
15,45
17,11
13,33
-0,69
0,52
7,95
8,75
16,20
-0,53
0,43
9,21
10,47
21,32
-0,77
0,41
10,12
11,43
26,10
-0,78
0,57
14,88
17,02

Average
Standard Deviation

15,13
5,65

-0,67
0,23

0,51
0,13

8,84
3,32

Forecasting
Error
0,93
0,93
0,94
0,94
0,60
0,01
0,78
0,01
0,42
1,14
1,67
0,80
1,26
1,31
2,14

9,77
3,78

0,92
0,54

H Test
Reject Ho Y/N
N
N
N
N
N
N
N
N
N
N
N
N
N
N
N
N

Table 5: Forecast and Measured Volatility and Risk Reduction for J=15, Long Short = 0, 5.

Forecast vs Measured Portfolio Volatility in %


20,00

18,00

16,00

14,00

Forecast

12,00

10,00

8,00

6,00

4,00

2,00

0,00
0,00

2,00

4,00

6,00

8,00

10,00

12,00

14,00

16,00

18,00

20,00

Measured

Figure 7: Forecast and Measured Volatility Scatter Plot for J=15, Long Short = 0.5, r2 = 0.99.

24

Year
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002

Measured
Measured Measured
Measured
Forecast
Mkt Sigma % L/S Correl
Beta
HF Sigma % HF Sigma %
12,29
-0,91
-0,51
6,46
7,20
13,65
-0,62
-0,63
10,07
10,29
21,50
-0,89
-0,65
13,75
15,00
17,32
-0,77
-0,79
14,39
14,66
9,46
-0,84
-0,40
4,48
5,02
8,61
-0,54
-0,33
5,20
5,31
10,90
-0,65
-0,63
7,33
8,21
5,21
0,34
-0,84
7,92
5,45
11,06
-0,62
-0,80
9,49
9,82
18,47
-0,67
-0,80
15,61
15,90
21,57
-0,73
-0,52
13,21
13,65
13,33
-0,32
-0,70
11,76
11,33
16,20
-0,65
-0,38
7,95
9,23
21,32
-0,65
-0,43
10,96
12,76
26,10
-0,85
-0,44
11,89
13,67

Average
Standard Deviation

15,13
5,65

-0,62
0,30

-0,59
0,17

10,03
3,31

Forecasting
Error
0,74
0,23
1,24
0,27
0,55
0,11
0,88
-2,47
0,33
0,29
0,45
-0,44
1,28
1,79
1,78

10,50
3,59

0,47
0,99

H Test
Reject Ho Y/N
N
N
N
N
N
N
N
N
N
N
N
N
N
N
N
N

Table 6: Forecast and Measured Volatility and Risk Reduction for J=15, Long Short = 0, 65.

Forecast vs Measured Portfolio Volatility in %


20,00

18,00

16,00

14,00

Forecast

12,00

10,00

8,00

6,00

4,00

2,00

0,00
0,00

2,00

4,00

6,00

8,00

10,00

12,00

14,00

16,00

18,00

20,00

Measured

Figure 8: Forecast and Measured Volatility Scatter Plot for J=15, Long Short = 0.65, r2 = 0.93.

25

Measured
Alpha
3,83
2,79
0,13
-0,45
-1,31
-1,52
-3,56
-0,86
-2,04
-4,41
-2,78

J (lookback period)
Days
2
5
10
15
20
25
30
35
40
45
50

Measured
Measured Measured
Mkt Sigma % L/S Correl
Beta
15,13
-0,62
-0,03
15,13
-0,75
-0,07
15,13
-0,68
-0,03
15,13
-0,72
-0,05
15,13
-0,65
-0,02
15,13
-0,68
-0,02
15,13
-0,65
0,01
15,13
-0,66
-0,03
15,13
-0,66
-0,02
15,13
-0,66
-0,01
15,13
-0,65
-0,02

Measured
Forecast
Forecasting
H Test
HF Sigma % HF Sigma %
Error
Reject Ho Y/N
6,32
6,47
0,15
N
5,12
5,62
0,51
N
5,97
6,15
0,19
N
5,63
5,91
0,27
N
6,22
6,32
0,10
N
5,85
6,03
0,18
N
6,18
6,32
0,14
N
6,28
6,53
0,25
N
6,43
6,60
0,17
N
6,21
6,31
0,10
N
6,37
6,51
0,14
N

Table 7: Average Study Period Performance Figures For Various J Parameters

26

Measured Alpha as a Function of J


5,00
4,00
3,00
2,00

Alpha

1,00
0,00
2

10

15

20

25

30

35

40

45

50

-1,00
-2,00
-3,00
-4,00
-5,00

Figure 9: Measured Alpha and J (Lookback period for Momentum Ranking).

Measured Absolute Alpha as a Function of Volatility Error

5,00
4,50
4,00

Absolute Alpha

3,50
3,00
2,50
2,00
1,50
1,00
0,50
0,00
0,15

0,51

0,19

0,27

0,10

0,18

0,14

0,25

0,17

0,10

0,14

Volatility Error

Figure 10: Measured Absolute Alpha versus Volatility Forecast Error, a=0, b=0.23, r2 =0.03.

27

6,00

5,00

4,00

Info Ratio

3,00

2,00

1,00

0
0,
28
0,
35
0,
43
0,
50
0,
58
0,
65
0,
73
0,
80
0,
88
0,
95

0,
13

0,
2

3
-0
,55
-0
,4
8
-0
,4
0
-0
,32
-0
,2
5
-0
,17
-0
,10
-0
,0
2
0,
05

-0
,6

-0
,78
-0
,70

3
-0
,85

-0
,9

-1,0

0,00

-1,00

-2,00

Beta

Figure 11: Long Short Information Ratio versus Beta, = 5, rm = 15, m = 10, = 0.7, rf = 3

28