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The importance of short portfolio breadth

Updated: Feb 14, 2023

Breadth is a very important concept in quant factor investing. The Fundamental Law of Active Management states that risk-adjusted returns are a function of the process’ predictive power (IC) and the number of independent bets (Breadth).


Quant models with high ICs do not exist. Equity markets are inefficient and mispricing anomalies exist, but even sophisticated quant models and factors only slightly skew the odds of success slightly to the portfolio manager’s advantage.


This is where breadth comes into play. If a large number of independent bets are taken, a slight edge over other market participants can generate strong risk-adjusted returns. This equates to having a large number of portfolio positions, based on a robust stock selection process, along with tight risk constraints.


An additional advantage of having a large number of short positions is that it mitigates stock specific risk. There is no limit to how much money can be lost on a short sale. I can never remember a time when this risk has been greater – even during the tech boom in the late 1990s. Excessive liquidity driven by ultra-easy monetary policies and increased retail investor participation has created an environment that isn’t conducive to short sales (witness the recent strong outperformance of GameStop and AMC).


Fortunately, the OQ Asia Absolute Alpha fund has a highly diverse short portfolio and is thus less exposed to stock specific risks posed by irrational share price moves than most other market neutral funds, particularly funds which focus on fundamental stocks analysis.


To achieve this high level of breadth and diversity in the short portfolio, we supplement our short alpha screens with short risk screens based on linear multi-factor quant scores. Where appropriate, we also short index futures contracts. While this isn’t a source of alpha, it is the cheapest and safest way to get short equity market exposure. We then conduct our risk analysis on a futures look-through basis.


Increasingly – and somewhat belatedly - investors and fund managers are recognizing the risks currently posed by having concentrated short equity bets. The following extract is from the Financial Times (25 June 2021):


“Some funds are considering taking a greater number of smaller short positions to cut down on the potential losses a single stock can cause, say industry insiders. D1 Capital, whose founder Daniel Sundheim previously worked at Viking, is one fund that has been considering reducing the size of short bets this year, say people familiar with the strategy. Others are looking at betting against indices, rather than individual stocks”.

While these funds need to modify their investment process to deal with the current market environment, we don’t. We already have the models, systems and expertise to manage a large number of short positions. This allows us to achieve market neutrality in a way that does not exposure investors to the significant drawdown risk that has decimated the returns of several hedge funds this year.

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