Chapter 31 - Short Selling in an Asset Allocation Framework—The Search for Alpha

Abstract

This chapter highlights the central role played by short selling in an institutional investor's portfolio. Introducing short selling in an asset allocation framework can enhance the performance of an investor's portfolio significantly. Short selling allows for separation of investments into beta and alpha exposure, which leads to better control of the asset allocation process. However, short selling market indices at an appropriate level to extract alpha is a complex process and requires skilled portfolio managers. There are three reasons for the complexity, which include finding an active manager with consistent positive alpha, estimating their beta exposure, and implementing short selling of beta exposure. An empirical study on a large data set demonstrated that transporting alpha from a fund of funds to a separate alpha fund implies large efficiency gains in the portfolio formation. It also shows that a fund of funds seems, to a large degree, to provide inexpensive beta exposure at a high fee.